Funds of Funds

The online version of the Wall Street Journal has written about Fund of Funds and their business model (being more of an asset gatherer as opposed to competent risk managers.)

The Recapitulator, not working in that industry, does not know the relative merits of this argument, but he can opine on the, to quote Mr. Gross of PIMCO, "Alpha Beta anemia problem".

A friend of mine outlined a good list for determining whether or not to invest something. I somewhat disagree with using the Sharpe ratio, with all of its weaknesses (for instance, one still has the problem of determining the appropriate "benchmark", and hopefully now my readers will indentify my disdain for "Beta" used as a proxy for "Risk")

In any case, here are the points he made:

"1. Did the study actually make money on an absolute basis? Why invest
in something which lost money but did relatively better than the market?

2. Did the study outperform the market on a risk adjusted basis? This is
equivalent to asking whether the Sharpe ratio of the study was better
than the market. If it did not this means that someone could have bought
the market portfolio with appropriate leverage or deleverage and either:
a) Outperformed your study with equal risk (despite the leverage)
b) Matched the return of the study but with less risk

3. If the study involves selecting either good days or good stocks out
of a given sample did the study outperform the overall average of the
sample? In other words if the sample has a built in bias did the study
outperform that bias?

4. The study should be statistically significant by all of the foregoing
metrics."

This is an excellent way to begin wether or not one should invest in Fund of Funds products. If diversity is a goal, one should be very careful how one describes the "market" to compute ex-ante or ex-post risk adjusted returns. Fund of Funds allows access to many different types of assets, and taking advantage of (historical) negative correlation has beneficial effects on a portfolio.

In other words, it is as it has always been. Caveat emptor. One must know what one is buying, and therefore an investor with Fund of Funds should have independent personell assess the relative expertise of the Fund of Funds shop.