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On the relative performance of multi-strategy and funds of hedge funds

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  • Agarwal, Vikas
  • Kale, Jayant R.
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    Abstract

    Recently, there has been explosive growth in two products from the hedge fund industry - multi-strategy (MS) funds and funds of hedge funds (FOFs), both of which offer diversification across different hedge fund strategies. In well-functioning markets, both investment vehicles should offer similar returns. Over the period 1994 - 2004, we find that MS funds outperform FOFs on a risk-adjusted basis by 2.6% to 4.8% per year on gross-of-fee and by 3.0% to 3.6% per year on net-of-fee basis. The superior performance of MS funds continues to hold even when we control for fund characteristics such as size, management and incentive fees, and other conventional control variables. Since FOFs underperform MS funds on both netand gross-of-fee basis, their underperformance cannot be entirely explained by their double-layered fee structure. The question then is how MS funds and FOFs can co-exist in equilibrium in view of the significant differential in performance? We suggest that investors perceive greater agency risk in the structure of MS funds relative to FOFs and therefore require greater compensation for investing in MS funds. MS funds are able to generate these higher returns because they possess greater investment flexibility and are able to invest in less liquid assets. It is also possible that MS funds generate greater returns because managers with better ability self-select into joining MS funds and the competition among MS funds results in the rents from superior ability being passed on to the investors in the form of better returns. Controlling for the differences in agency risk, flexibility, and fee structure between MS funds and FOFs, our results suggest that self-selection by managers with superior ability in MS funds may be the driving force behind their superior performance relative to FOFs. --

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    Bibliographic Info

    Paper provided by University of Cologne, Centre for Financial Research (CFR) in its series CFR Working Papers with number 07-11.

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    Date of creation: 2007
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    Handle: RePEc:zbw:cfrwps:0711

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    Related research

    Keywords: Multistrategy hedge funds; funds of hedge funds; performance; fees; agency risk; investment flexibility;

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    References

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    1. Carhart, Mark M, 1997. " On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, American Finance Association, vol. 52(1), pages 57-82, March.
    2. Fung, William & Hsieh, David A, 1997. "Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 10(2), pages 275-302.
    3. Fama, Eugene F & MacBeth, James D, 1973. "Risk, Return, and Equilibrium: Empirical Tests," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 81(3), pages 607-36, May-June.
    4. Andrew Ang & Matthew Rhodes-Kropf & Rui Zhao, 2008. "Do Funds-of-Funds Deserve Their Fees-on-Fees?," NBER Working Papers 13944, National Bureau of Economic Research, Inc.
    5. Stephen J. Brown & William N. Goetzmann & Bing Liang, 2004. "Fees on Fees in Funds of Funds," Yale School of Management Working Papers, Yale School of Management ysm18, Yale School of Management.
    6. Capocci, Daniel & Hubner, Georges, 2004. "Analysis of hedge fund performance," Journal of Empirical Finance, Elsevier, Elsevier, vol. 11(1), pages 55-89, January.
    7. Daniel Capocci, 2002. "An Analysis of Hedge Fund Performance," Finance, EconWPA 0210001, EconWPA.
    8. Stephen J. Brown, 2001. "Careers and Survival: Competition and Risk in the Hedge Fund and CTA Industry," Journal of Finance, American Finance Association, American Finance Association, vol. 56(5), pages 1869-1886, October.
    9. Fung, William & Hsieh, David A & Naik, Narayan & Ramadorai, Tarun, 2006. "Hedge Funds: Performance, Risk and Capital Formation," CEPR Discussion Papers, C.E.P.R. Discussion Papers 5565, C.E.P.R. Discussion Papers.
    10. Carl Ackermann & Richard McEnally & David Ravenscraft, 1999. "The Performance of Hedge Funds: Risk, Return, and Incentives," Journal of Finance, American Finance Association, American Finance Association, vol. 54(3), pages 833-874, 06.
    11. Agarwal, Vikas & Naik, Narayan Y., 2005. "Hedge Funds," Foundations and Trends(R) in Finance, now publishers, vol. 1(2), pages 103-169, November.
    12. Liang, Bing, 2000. "Hedge Funds: The Living and the Dead," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 35(03), pages 309-326, September.
    13. Vikas Agarwal, 2004. "Risks and Portfolio Decisions Involving Hedge Funds," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 17(1), pages 63-98.
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    Cited by:
    1. Yang CAO & Joseph P. OGDEN & Cristian I. TIU, 2011. "Who Benefits From Funds Of Hedge Funds? A Critique Of Alternative Organizational Structures In The Hedge Fund Industry (I)," Business Excellence and Management, Faculty of Management, Academy of Economic Studies, Bucharest, Romania, vol. 1(1), pages 19-36, December.
    2. Yang CAO & Joseph P. OGDEN & Cristian I. TIU, 2012. "Who Benefits From Funds Of Hedge Funds? A Critique Of Alternative Organizational Structures In The Hedge Fund Industry (Ii)," Business Excellence and Management, Faculty of Management, Academy of Economic Studies, Bucharest, Romania, vol. 2(1), pages 5-20, March.
    3. Kolokolova, Olga, 2011. "Strategic behavior within families of hedge funds," Journal of Banking & Finance, Elsevier, Elsevier, vol. 35(7), pages 1645-1662, July.
    4. Agarwal, Vikas & Nada, Vikram & Ray, Sugata, 2013. "Institutional investment and intermediation in the hedge fund industry," CFR Working Papers 13-03, University of Cologne, Centre for Financial Research (CFR).

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