Younger funds of funds less volatile, more diversified and less leveraged: Why?

17 Feb 2009

Given that Bernie Madoff had been (allegedly) running a hedge strategy for 2 decades by the time he packed it in, it’s not a huge surprise that many Madoff feeder funds weren’t spring chickens either.  Some were nearly as old as Madoff’s fund management business itself.  The seasoned funds of funds that invested in Madoff have now experienced a significant bump in their return volatility.  Meanwhile, younger funds (say, under a few years old) are less likely to have been able to join the exclusive Madoff feeder fund club.

This situation might have come as little surprise to the authors of a study published in this quarter’s Journal of Alternative Investments.  Ying Li and Jamshid Mehran of Indiana University examine the performance and risk profiles of “seasoned” and “new” funds of funds.  Their article is available for a limited time at the Chartered Alternative Investment Analyst (CAIA) website.

Contrary to their image of naive and overconfident johnny-come-latelies, younger funds of funds actually have a lower volatility than older more established funds of funds.  One of the reason for this is that gross leverage appears to be higher for the older funds than for the spring chickens (although as Li and Mehran point out, they estimate leverage by adding up the various beta exposures in a fund, so a higher volatility and higher implied leverage kind of go hand in hand).

And here’s a finding will surely make sense to Madoff victims: another reason for the higher volatility of seasoned funds of funds is that they tend to me more concentrated than newer funds of funds.

2001: A Fund of Funds Odyssey

Think there has been an explosion in funds of funds over the past few years?  There may have been a lot of institutional assets flowing into funds of funds, but according to data presented in this study, the halcyon days for fund of funds launches actually happened in 2001 (see chart below from paper).

Caution out of the gate

Studies have apparently shown that seasoned equity managers tend to take more active bets – hugging the index less that their newbie peers.  According to Li and Mehran, the same may be true for funds of funds. The volatility of funds of funds that were over 4 years old was higher than the volatility of the relative newcomers during a sample window of 1995-2001 (although the volatilities converged around the turn of the century).

When the authors regressed the returns of seasoned and new funds of funds against 13 factors (ranging from equity and bond factors to non-linear factors), the found that the sum of all 13 betas was much higher in the “seasoned” fund of fund category than it was in the “new” category.  Whether or not, this higher systematic exposure was the result of actively taking on leverage or whether it was the result of investing in more inherently volatile (or more levered) underlying managers is moot.  Instead, Yi and Mehran argue that a higher sum of betas (“Gross Leverage Measure” or GLM) implied leverage no matter how you define it.

On this basis, the seasoned funds used more “leverage”.  In fact, over the 1995-2003 period the average GLM for seasoned funds was almost a third higher than it was for the new funds.

The lower beta and volatility of new funds may be a result of their propensity to spread their money around to a large number of managers.  Li and Mehran use a measure of portfolio concentration called the “Herfindhal Measure” that is based on the diversity of risk factors inherent in each fund of funds.  A high number of small risk exposures yields a small Herfindhal Measure while a low number of large risk exposures gives rise to a large Herfindhal Measure.

The Herfindhal Measure for seasoned funds of funds was a third higher than it was for new funds, suggesting new funds were more diversified across risk factors and that seasoned funds relied more heavily on a smaller number of risk factors.  This doesn’t necessarily mean that seasoned funds invested in fewer funds, but it does suggest that their returns could be explained by fewer factors.  So, like leverage, concentration need not be defined literally in order for the concept to be useful.

“Entrenched” Managers?

In conclusion, Yi and Mehran point out the apparent irony of seasoned, well-connected funds of funds managers having less diversified portfolios even though you’d think they’d know more potential managers.  This prompts them to ask a question that may be on the minds of some funds of funds who invested in Madoff:

“Are the more seasoned funds of funds managers more ‘entrenched’?”

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