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Hedge funds: The myth of FoHFs’ added value

Claims of special access to the best managers and extraordinary due-diligence skills are not rooted in reality.

The HFRI fund of hedge funds index lost 20% over 2008, while the average hedge fund in HFR’s database lost 18%. The argument that a fund of hedge funds can spread risk and so is less likely to lose money than an individual fund is emerging as nothing more than wishful thinking. Indeed other than in 2007, the HFR fund of hedge funds index has returned less than the average hedge fund in a profitable year, and lost more in down years. By the end of the fourth quarter of 2008, fund of hedge funds assets had fallen to $593 billion from a peak of $825 billion.

The added value of funds of hedge funds is being tested on several levels. Originally, funds of hedge funds were considered to be spreading risk. Correlation among hedge fund strategies was perceived to be low, so an allocation across several strategies would spread risk and increase the chance of good returns.

But by 2007 it was becoming clear that correlation between hedge fund strategies was increasing. Although low volatility was blamed for this, later events, and indeed the LTCM blow-up in 1998, show that volatility has little to do with correlation.