Funds Of Funds: Are They Picking The Best?

In pitches to prospects, funds-of-funds managers can point to a trio of industry truisms to hammer home the value of their products.

The first: Median returns in our business are mediocre. If you want to make good money as a limited partner, you have to back top-quartile performers. The second: Top-quartile firms tend to repeat their stellar achievements fund after fund. (This truism is a little shakier, but there’s still plenty to it.) The third: It’s becoming more and more difficult to secure allocations with these repeat performers because prior investors are throwing so much money at them.

The three truisms add up to a problem for the less-well-connected limited partner. The solution, say some: Commit money to a fund-of-funds manager that has developed cozy ties with these top-quartile firms. Whatever extra money you pay in fees to the manager should be more than made up for in the form of extra returns.

But based on an analysis of return data from six public pension and endowment funds—the only six I could find that had funds of funds in their portfolios—investments in funds of funds don’t always perform that well.

The six are California Public Employees’ Retirement System (whose performance data is current through year-end 2006), Colorado Public Employees’ Retirement Association (year-end 2006), New York Common Retirement Fund (March 31, 2006), Oregon Public Employees’ Retirement Fund (Sept. 30, 2006), University of Texas Investment Management Co. (Feb. 28, 2007) and the Washington State Investment Board (year-end 2006). Here are some statistics that I generated on their funds-of-fund investments, bearing in mind they don’t all provide equivalent performance metrics:

• By my count, together these six institutions invested $5.8 billion in U.S. and international funds of funds through 1985 to 2002-vintage funds. In all, they made 42 separate commitments to 27 different funds (they often backed the same funds), managed by nine different funds-of-funds managers. The six have lost money on nearly a quarter of these deals, or at least 10 of these 42 separate investments.

• Subtracting eight funds of funds that lack valuation data leaves 34 of the original 42. The $5.4 billion that the six institutions invested in those 34 funds is valued at $6.2 billion today, for a rather unstellar 1.1x multiple. For comparison, if these six had invested $5.4 billion in an S&P 500 index fund at the end of 1996, and sold 10 years later, they would have generated $10.3 billion in proceeds, for a 1.9x multiple.

• For 34 of the 42 separate investments, the institutions supplied multiples in their performance reports. The median multiple for those 34 investments is 1.1x, and they range from 0.5 to 3.2. Just three funds of funds cleared the 1.5x mark. For 27 of the 42, the institutions supplied internal rates of return (IRR). The median IRR for those 27 is 9.4 percent, and they range from -13.5 percent to 41.8 percent. Just three co-mingled pools in my sample cleared the 20 percent mark.

• One could argue it’s not fair to overweight certain funds of funds simply because more than one institution in my sample committed to it. Fair enough. But melting out the duplicate funds produces virtually the same results—an investment multiple of 1.2x, a median multiple of 1.1x and a median IRR of 8.5 percent.

Now, I have no idea whether funds of funds as a community are delivering strong returns for investors. This is just a sample. And funds of funds do boast many virtues, beyond the one mentioned above, that make them ideal vehicles for many investors. They’re particularly appropriate for those lacking the money or resources to build and manage a diversified portfolio on their own.

But my analysis does suggest that prospective investors should do plenty of legwork to learn how funds of funds have performed, and whether they deliver on their promises. Indeed, there’s evidence that these six institutions have ratcheted back their use of funds of funds. These six invested an estimated $4.5 billion in vintage-year 1996 to 2000 funds of funds; in the next five vintages, 2001 to 2005, they invested just $864 million. Any number of reasons could account for this beyond performance. For example, many investors use funds of funds as training wheels before graduating to picking their own funds. I was unable to reach executives at these six pension and endowment funds for comment.

Want a copy of my spreadsheets used for this analysis? Just shoot me an email at

Correction: Numbers in the first and fourth bullet points of this story have been corrected. Originally the first bullet point said that the six institutions made 42 separate commitments to 30 different funds managed by 11 different funds-of-funds managers; the actual numbers are 27 different funds managed by nine different funds-of-funds managers. The original 9.1 percent median IRR in the fourth bullet point has been corrected to 8.5 percent.