Global Macro and Fund of Funds

I received an email from one reader the other day asking me about setting up a fund-of-funds approach to global macro investing. It wasn’t clear to me at the time whether the author was asking about setting up 1) a fund of global macro hedge funds, or 2) a fund of hedge funds to implement global macro strategies. Both of these are potentially mechanisms for global investing, but they present different investment challenges and require different management skills to execute correctly.

With these questions, one needs to consider what the advantage of a fund-of-funds approach is in the first place. I see four basic ways in which fund-of-funds approach can add value: it provides diversification benefits, it can allow a degree of tactical or cyclical strategy allocation, a publicly-traded fund of funds might allow ordinary (i.e. non-sophisticated) investors to have access to hedge fund returns through equity returns, and finally, it may simply be the appropriate business structure for managing an individual investor’s wealth, or a family office. I discuss some of these benefits below.

Diversification

First, a fund-of-funds provides some diversification against manager risk. This is the risk that an individual manager will make a major mistake, turn out to be crooked, be hit by a bus, leave the firm, or some other unexpected event that impinges on a fund’s key productive asset. To be truly diversified against this risk might require some 20 funds or so, which is probably larger than most fund-of-funds prefer to allocate. If all the funds revolve around the same basic strategy, the diversification against manager risk is largely achieved.

In addition, one could diversify amongst multiple strategies, which would help protect against specific hedge fund strategies moving in and out of favor. Optimizing the allocations to specific hedge funds in a diversified fund approach may be a challenge, because of short price histories and hidden risks may introduce substantial estimation error and result in underestimation of portfolio risks. In addition, optimization would likely be constrained to long-only portfolios of hedge funds, as there are few ways for a hedge fund to directly short another hedge fund (but see point three, and there might be).

Strategic, tactical, and cyclical asset allocation

Secondly, a fund of hedge funds approach might offer an opportunity to engage in tactical or cyclical asset allocation by systematically adjusting the weights given to different funds in response to changing short or medium-term market expectations. For example, if a convertible arbitrage strategy does well in a higher volatility environment, then one may want to overweight the allocation to these strategies relative to the strategic allocation if the forward economic environment looks choppier. To succeed here requires a very careful understanding of manager strengths and weaknesses, a reliable feel for the economic environment, and knowledge of how the two will interact. It is also complicated by liquidity constraints, given that hedge funds may involve lockup periods that interfere with the ability to rebalance on a tactical basis. Indeed rebalancing allocations even to the strategic targets can run into liquidity difficulties.

Hedge Fund Accessibility

It is conceivable that a fund of hedge funds could be a public company, and if there were a policy of not offering dividends, then the book value of assets should grow more or less in line with fund performance and offer ordinary non-sophisticated investors an opportunity to receive hedge-fund-type returns by purchasing the fund’s stock. Moreover, if the fund stocks are available and representative of net asset values, investors could take short positions in these stocks to implement views of negative fund performance. One might conceivably create indices of hedge fund strategies: merger-arb, convertible-arb, distressed debt, etc. type equities could proliferate much in the manner that exchange-traded-funds do today. Relative value and special situations strategies lend themselves most readily to this type of securitization, but there is no reason that one could not attempt to try this with more directional funds as well.

Part of the challenge of this structure is that the market price of a fund’s stock will reflect not only the net asset value, but also discounted expectations for future fund growth. Thus the stock price will likely have greater volatility than the underlying NAV, reflecting changes in public sentiment and growth expectations.

Logical Business Structure

For high net worth clients and family offices, a fund-of-funds structure may simply be the best business structure to take advantage of the opportunity for hedge-fund style returns without committing to a single fund or strategy, and without requiring the institutional and personnel overhead necessary for creating and managing one’s own hedged strategies on a day-to-day basis. On the surface, this is simply a reiteration of the diversification argument, but while the diversification argument might be made by an existing fund to obtain an external investor’s money, the business structure argument is for a person who already possesses substantial funds and effectively needs to create a business structure for the purpose of managing their own money. In this context, diversification is required practically by definition. That a family office would be a fund of funds, but the funds invested in might not be individually diversified is similar to the argument against conglomerates: the idea here is that investors should decide how to diversify in by choosing what companies to invest in, and therefore do not need companies with diversified businesses lines to provide diversification for them within a single stock.

Funds of Global Macro Funds

What does this mean about global macro funds of funds? I am eager to discuss how to think about the challenges of managing of a fund of global macro funds, but that will have to wait until the next installment.