David Swenson: Questions Value of the Hedge Fund of Funds

Yale University's David Swensen topped the list of endowment returns in the latest fiscal year that ended in June, according to Bloomberg survey of 25 largest endowments.

It was no one-year anomaly either. Swensen produced an average annual return of 17.4 percent during the past decade. How did he do it? With significant allocations to alternative assets, including hedge funds, real assets (including real estate timber and energy), and private equity. It is not coincidental that the was also one of the first endowments to invest in real estate and hedge funds early, both alternative investment categories.

Swenson is not an enthusiastic support of mutual funds or hedge fund of funds, suggesting that the fee structures of these vehicles make it difficult to add value over the unmanaged alternatives that have become available.

In the hedge fund arena, the addition of a typical 1% management fee and 10% incentive fee (on top of the underlying funds' fees) does make it difficult for a fund of funds to outperform. However, fund of funds often claim their value comes from:

Access to funds otherwise closed to investors. We would amend this as access to superior management (whether closed or open.) If the "closed managers" underperform their strategy, most investors won't care that they're invested with closed managers.

Ability to optimally allocate to strategies and shift assets to outperforming strategies. This is the tactical asset allocation argument, applied to hedge funds. Several funds have alluded to this possibility.

Ability to leverage the hedge fund portfolio somewhat for extra return. Financing may be more available to a fund than an individual. If the fund of fund has done a good job in contructing the portfolio, some leverage at the fund of fund level may be reasonable.

Are hedge fund of funds able to use these techniques to overcome their management and incentive fees. As a group, probably not. But these are the questions an investor must ask if considering a hedge fund of fund.