Determinants of Funds of Hedge Funds' Performance

Abstract

Despite institutional investors' growing interest in funds of hedge funds, little attention has been paid thus far to their added value and/or the sources of their added value. This is all the more striking in that funds of funds are far from transparent and are, with their double-fee structure, relatively costly investment vehicles. The authors' objective, as explained in this article, is to fill this research gap and find out whether funds of funds add value through strategic allocation and active management. To this end, the authors ran a return-based style analysis on a sample of 97 funds of funds over the period from 1997 to 2004. The authors found that 89% of the funds of funds added value at the strategic allocation level, but only 31% added value at the active management level. Finally, only 20% of funds of funds created value through both strategic allocation and active management. In other words, if picking best performingfunds is a challenging task, picking best performing funds of funds appears to be equally difficult.