Chapter 14
The Paradox of Hedge Fund of Funds Underperformance
Compare a hedge fund index constructed from single hedge funds with one constructed from funds of funds and you will notice an odd thing: The index based on funds of funds will tend to consistently underperform. Not only are the fund of funds returns lower in almost every year, but the magnitude of their underperformance is quite substantial, with annual performance lags of 5 percent or more commonplace in the historical record.
Is the apparent substantial underperformance of fund of funds managers another example of what might be termed “Eckhardt’s dictum”? Bill Eckhardt is one of the managers I interviewed in The New Market Wizards.1 In that interview, Eckhardt asserted that human nature was so poorly attuned to trading and investing decisions that most people would do worse than random. To be clear, Eckhardt was not saying the equivalent of the proverbial academic claim that a monkey throwing darts at the Wall Street Journal stock quote page could do as well as fund managers; Eckhardt was saying that the monkey would do better! In his view, the innate human tendency to seek comfort, honed by evolution, will lead most people to make worse than random trading and investment decisions. Are we to conclude that fund of funds managers should exchange their fund selection, due diligence, portfolio construction, and monitoring processes for a good set of darts?
Part of the explanation for the underperformance of funds of ...
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