On the Relative Performance of Multi-Strategy and Funds of Hedge Funds

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 hedgefund strategies. In well-functioning markets, both investment vehicles should offer similar returns. Overthe 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 ofMS funds continues to hold even when we control for fund characteristics such as size, management andincentive fees, and other conventional control variables. Since FOFs underperform MS funds on both netandgross-of-fee basis, their underperformance cannot be entirely explained by their double-layered feestructure. The question then is how MS funds and FOFs can co-exist in equilibrium in view of thesignificant differential in performance? We suggest that investors perceive greater agency risk in thestructure of MS funds relative to FOFs and therefore require greater compensation for investing in MSfunds. MS funds are able to generate these higher returns because they possess greater investmentflexibility and are able to invest in less liquid assets. It is also possible that MS funds generate greaterreturns because managers with “better” ability self-select into joining MS funds and the competitionamong MS funds results in the rents from superior ability being passed on to the investors in the form ofbetter returns. Controlling for the differences in agency risk, flexibility, and fee structure between MSfunds and FOFs, our results suggest that self-selection by managers with superior ability in MS funds maybe the driving force behind their superior performance relative to FOFs.