by
Global Alternative Investment Strategist

Weekly market insights from the Global Investment Strategy team

  • The current trailing 12-month hedge fund-of-funds return is more than three times its average return since 2009. 
  • Hedge fund of funds are not designed to deliver outsized gains. Rather, they can offer diversification and seek to provide stable returns with low correlations to broad markets. 

What it may mean for investors

  • The combination of lower fees and better performance from a hedge fund of funds’ underlying hedge funds has resulted in an improvement in fund of funds’ net returns compared to the past few years.  We expect this trend to continue. 
  • At this point in the cycle, we believe that mid-single-digit returns and low-to-negative correlation versus global fixed income investments can be quite compelling.

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Despite reports of their untimely demise, Hedge fund of funds (“FoFs”) are slowly, but surely, emerging from a difficult stretch—as a deficiency in alpha1 from underlying hedge funds, coupled with an added layer of fees, had stymied net returns. This, in turn, led to redemptions, industry consolidation, and even an occasional return of capital and firm closure. Yet, the twin tailwinds of higher growth and rising interest rates are improving returns from active management. The HFRI Fund Weighted Composite Index has generated a 12-month return that exceeded 8 percent, more than twice its average since January 2009.  Indeed, better returns from underlying managers can translate to better returns for Hedge FoFs. The current 12-month return for the HFRI Fund of Fund Composite Index is 5.6 percent, more than three times its average since January 2009.  (It is important to note that an index is unmanaged and not available for direct investment.) Though we always are cognizant of the fluidity of global markets, we do see a more stable environment for active management as central banks become less accommodative and interest rates rise. In other words, we believe that there may be some durability to the stronger performance trends we recently have seen—and a compelling opportunity for investors to reconsider Hedge FoFs for their overall portfolios.

Remember the Objective of Fund of Funds 

Hedge FoFs are designed to provide stable, but not necessarily outsized, returns. Because Hedge FoFs normally allocate to dozens of underlying hedge funds, each with different strategies and exposures, one can think of a Hedge FoF as offering global asset allocation in an actively managed structure. In fact, as Chart 1 illustrates, Hedge FoF returns generally exhibit much of the same cyclicality as a blended portfolio of global equities and global fixed income, but with less volatility. 

Chart 1. Hedge FoF Returns Have Largely Tracked Those of a Global Portfolio—But with Less Volatility


Chart 1. Hedge FoF Returns Have Largely Tracked Those of a Global Portfolio—But with Less Volatility
Source: HFR, Bloomberg, Wells Fargo Investment Institute, June 2017. Chart is for illustrative purposes only and shows that Hedge FoFs as represented by the HFRI Fund of Funds Composite Index have had lower historical volatility than that of a global portfolio composed of equities and fixed income investments. The 60/40 portfolio is composed of 60% global equities represented by the MSCI World Index and 40% global fixed income represented by the Bloomberg Barclays Global Aggregate Bond Index.

Performance results for the 60/40 Portfolio are hypothetical and do not represent actual trading. The indices reflect the historical performance of the represented assets and assume the reinvestment of dividends and other distributions, if applicable.  Index returns reflect general market results, do not reflect actual portfolio returns, the experience of any investor, or the impact of any fees, expenses or taxes applicable to an actual investment.  Unlike most asset class indices, HFR Index returns reflect fees and expenses. An index is unmanaged and not available for direct investment. Hypothetical and past performance does not guarantee future results.  Each asset class has its own risk and return characteristics.  The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. There is no direct correlation between an index and the anticipated performance of any fund.  Please see the end of the report for the risks associated with the representative asset classes and for definitions of the indices.

While Hedge FoFs are sensitive to global equity markets, they historically have low-to-negative correlation with global fixed-income investments (as seen in Chart 2). This historical relationship aligns nicely with Wells Fargo Investment Institute’s (WFII) current tactical asset-allocation view.  WFII currently is underweight developed market (ex-U.S.) fixed income. We believe that having a lower correlation to global fixed income is an important consideration for investors, especially at a time when central bankers appear poised to raise rates as global economic growth improves.

Chart 2.  Hedge FoFs Historically Have Low-to-Negative Correlation with Global Fixed Income


Chart 2.  Hedge FoFs Historically Have Low-to-Negative Correlation with Global Fixed Income
Source: HFR, Bloomberg, Wells Fargo Investment Institute, June 2017. Chart shows the rolling 36-month correlation of the HFRI Fund of Fund Composite Index to the Bloomberg Barclays Global Aggregate Bond Index.  The average line represents the average rolling 36-month correlation from January 1990 through May 2017.  January 1990 is the first month available for HFRI Fund of Fund Composite Index data. Correlation represents past performance.  Past performance is no guarantee of future results.  There is no direct correlation between an index and the anticipated performance of any fund. An index is unmanaged and not available for direct investment.    There is no guarantee that future correlations between the indices will remain the same.

Are Mid-Single-Digit Returns Compelling?
We believe a Hedge FoF portfolio with a low-to-negative correlation to global fixed income that has the potential to return mid-single-digit returns to be a compelling opportunity. Going back over 27 years and multiple market cycles, Hedge FoFs, as represented by the HFRI Fund of Funds Composite Index have had an average 12-month return of 6.7 percent, whereas individual hedge funds, as represented by HFRI Fund Weighted Composite Index have had a comparable average return of 9.9 percent.  A simple, equally weighted combination of hedge fund of funds and hedge funds could generate a potential average annual return of 8.3 percent.  The mid-single-digit Hedge FoF returns we expect going forward might not have seemed compelling early in the cycle when equity prices are usually depressed and credit spreads are wide, but that is not where we find ourselves currently. In fact, it now is increasingly difficult to find “passive” investment opportunities that can deliver the level of expected returns and diversification investors demand for a diversified portfolio of alternative investments.  In our view, turning to Hedge FoF at a point when trailing 12-month returns are just beginning to highlight the improving opportunity set is a compelling option and one that we are strongly advocating.

Investment Implications
In general, the most recent three or five year annualized returns of for Hedge FoFs, and active management have been lower than historical averages. Yet, we believe those investors who are waiting for returns to normalize risk being underallocated at precisely the wrong time. The hedge fund industry is in the throes of change: fees are being compressed while performance is improving. We believe that the combination of the two developments implies better net returns for Hedge FoFs. Furthermore, there is, and likely will continue to be, large dispersion among hedge fund returns, which means that manager selection will be a critical driver of alpha generation. We always have believed that Hedge FoF should be considered a core component of a global asset-allocation strategy, and we are keen to remind investors that Hedge FoFs are, in fact, not dead, but rather in the early stages of resurgence.