Yesterday we told you about a 2006 study of the SEC’s “Form ADV”. Academics questioned whether the form - a centerpiece of the SEC’s plan to regulate hedge funds that year - was “redundant” since the due diligence performed by many hedge fund investors reveals the same information anyway.
Today, we continue on the theme of hedge fund due diligence with a look at another study co-authored by two of the same authors. In “Hedge Fund Due Diligence: A Source of Alpha in Hedge Fund Portfolio Strategy“, Stephen Brown, Thomas Fraser and Bing Liang examine the value of the due diligence performed by funds of funds. This is a particularly relevant issue right now as funds of funds come under criticism for not being able to forecast the Madoff saga.
Brown, Fraser and Liang cite a previous study that most hedge fund liquidations involved an operational component and over half of hedge fund liquidations prior to 2003 were the result of “operational issues alone”. In fact, that study (by Feffer & Kundro) found that:
- 41% of liquidations involved “misrepresentation of investments and performance”,
- 30% involved “misappropriation of funds and general fraud”,
- 14% involved “unauthorized trading and style breaches,and,
- 15% involved “inadequate resources” or “other operational failures”
Brown, Fraser and Liang estimate that the average fund of funds due diligence effort costs US$50,000 to US$100,000 per underlying fund. Like any fund cost, it represents a net against alpha. Expenses and management fees, after all, are uncorrelated to returns and therefore are pure (and negative) alpha.
Therefore, as fees fall, alpha rises. Since due diligence costs are essentially fixed, the larger the fund of funds, the lower the fee per dollar of assets. So more AUM in a fund of funds necessarily leads to greater alpha, ceteris paribus.
Great theory. But does the empirical evidence support this hypothesis? Yes, according to the authors:
“Alphas of large funds of funds are significantly higher than those of small funds of funds, evidence of significant economies of scale…”
“Funds of funds large enough to absorb the high cost of due diligence have in principal a significant competitive advantage over smaller funds of funds.”
By comparison, there appear to be dis-economies of scale for single-manager hedge funds. The authors divided single-manager funds into AUM quintiles and compare their performance. It turned out that the largest single-manager funds (quintile #5) actually had the lowest returns.
The study also made another interesting observation. It found that larger funds were more likely to use more “well known” service providers (auditors, administrators, counsel etc.). While this makes intuitive sense, the authors propose it as evidence that small funds (single-manager and FOFs) “lack the necessary funding to compete effectively with their larger brethren”.
Despite concentration in the accounting industry, the study found that only 26.8% of single-manager funds and 30.9% of funds of funds actually used “well known” auditors (i.e. those who were used by more than one other fund ). Less than half of the largest funds of funds used well known auditors and only a third of the largest single manager funds used them.
So smaller funds of funds face a double-whammy. They sacrifice alpha in the form of higher due diligence costs and they lack the marketing benefits of well known service providers.
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