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First Mutual Funds, Now Pension Funds

Souring on the fund of funds structure.

John Rekenthaler, 10/10/2013

Barnacles on the Keel
Several years back, funds of hedge funds were all the rage. Hedge funds were the glamor investment, and what better way for institutions (or wealthy individuals) to start their hedge fund collection than with a fund of funds? Let the professionals cull the frauds, and get diversification in the process. The concept was so popular that a few trendsetters even talked of cubed funds--funds of funds of hedge funds, i.e. funds that would purchase only funds of hedge funds. Now that's diversification!

The fashion has passed. Funds of hedge funds are in redemptions and besieged with bad publicity, for the simple reason that they haven't made money. North Carolina's pension fund, for example, is shutting down its allocation to funds of hedge funds because of "high costs and weak performance," according to a spokesman for the state's Treasurer. In aggregate, the state's funds of hedge funds lost 0.5% per year through June 30, 2013, as opposed to the 5.1% gained by balanced mutual funds ("moderate allocation" funds per Morningstar's lingo).

To be sure, part of this underperformance owes to problems with the underlying funds. Hedge funds haven't been good for almost a decade now. They ran dry of hedged-trade ideas in the middle of last decade, hitched their wagon instead to rising global stock markets, took a beating in 2008 as stocks went down everywhere, and have since struggled to find their collective identity. They still haven't found good hedged trades, nor have they been willing to hop aboard the renewed stock-market rally. In a word, they've been pffft.

But the fund of funds structure hasn't helped matters, either. Funds of funds haven't selected especially successful hedge funds, they haven't shown a special ability to detect frauds (one of the largest, most prestigious providers was lousy with Madoff funds), and the second layer of fees has bitten heavily into returns. An extra one percentage point of expenses per year, plus a 10% charge on profits (above a hurdle rate that varies by fund), demands that funds of hedge funds managements be outstanding to compensate for those high levels of costs. They haven't been.

Similar problems have beset private equity funds. According to a consultant's recent study, the median internal rate of return for funds of private equity funds that were launched between the years 2000 and 2009 was 6%--an unacceptable figure for an illiquid, volatile, leveraged investment. Again, the fee drag has been a killer. As the consultant points out, the fund of funds structure removes as much as 30% of the profit when the underlying funds rise by 5%. Under that condition, the second layer of fees amounts to about 1.5%, thereby cutting the net gain enjoyed by the investor to 3.5% from 5.0%.

Ironically, given their reputation as being the last to the investment party, mutual fund investors learned the fund of funds lesson 20 years past. In the 1980s, several companies sponsored funds of mutual funds that, like the hedge fund and private equity versions, touted their independence and ability to select the best underlying managers. These funds no longer exist. They didn't carry the drag of the performance fee that hampered funds of hedge funds and funds of private equity funds, but even their flat 1% management fees proved too great a burden. With the underlying mutual funds charging another 1% or so, the all-in charge was a performance-killing 2%. Returns were indeed mediocre and investors looked elsewhere.

The idea of a fund of funds is sound. The execution hasn't yet been there, though.

The problem for funds of hedge funds and funds of private equity funds was straightforward: They charged far too much. Layering 1% plus a performance fee on top of underlying funds that have even higher management fees and even bigger performance fees is putting too much weight on the back of the mule. As baseball manager Billy Martin would say, you can kick that mule in the tail all you want, but it won't become a racehorse. It will always be an overladen mule.

is vice president of research for Morningstar.

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