This is an excerpt from a story that originally appeared in the May edition of AsianInvestor magazine. To learn more about the content in the magazine, please contact Stephen Tang at [email protected] or on +852 2122 5239.

Can funds of hedge funds perform, or even out-perform when compared to hedge funds?
Are fund of hedge funds returns really uncorrelated and do their drawdowns show that they do mitigate risk? Having outperformed during one year, can they repeat the feat again and again?

All these are difficult questions to answer, but if you are paying the fees for a fund of hedge funds, they are fair questions, and you definitely should want to know the answer. The market turmoil in tandem with hedge-fund blow ups is making it easier to see which funds of hedge funds are worthwhile.

So, AsianInvestor has put on its quantitative investigator's hat. We have compiled four analytic criteria that an investor can use to test a fund of funds. We then took the top 10 performing funds of hedge funds that reported into Eurekahedge in 2008 and dissected them against each of these tests, using as the relevant index benchmarks the Eurekahedge Asian hedge fund index and the MSCI Asia Pacific index.

The criteria we applied to the funds of hedge funds are as follows:

1) Can it outperform a relevant hedge fund index? (In particular in a bull market, therefore adding value by manager selection.)
2) Does the fund of funds have lower drawdowns than the chosen hedge-fund index?
3) Does the fund of funds have low correlation to the hedge-fund index plus a relevant long-only index?
4) Time -- the fourth dimension. Can the fund of funds repeat all the above consistently in multiple market environments?

For the complete analysis, see the May edition of AsianInvestor magazine.

The winner
In conclusion, we have to sum up and choose a winner. As one evaluates each of the four criteria and the hurdles get taller, the contenders drop away. All of the funds that we have appraised have performed well. There are dozens of funds of hedge funds who have come nowhere near to them.

Persistent Edge China had impressively low correlations, and a good 2008 result in the context of China, but only 18 months of results. Having a relatively brief period of existence is also the feature with most of these funds, and for our winner, we do want to see year-to year results, in order to prove that a fund of hedge funds can handle bull and bear markets, plus volatile and non-volatile trading conditions.

In terms of results, APAM Absolute Equity Asia Fund shot out the lights in 2008, but looking closer, its 18% positive return in October, at a time when the MSCI Asia Pacific index fell by 19%, was actually due to profits from a currency overlay. Hence they were heavily inversely correlated and their accomplishment was not wholly due to fund selection.

So, there can only be one winner in these playoffs, and our winner then is Persistent Edge Asia Partners, whose correlations and drawdowns are low, and most importantly -- the hardest criteria to crack -- it has a track record of beating the markets every year.

Even qualifying on three out of four of our criteria might entitle a fund of hedge funds to merit an investor's interest. These are hard logical comparatives that we have used, and we think that they do distinguish the wheat from the chaff. When it comes to paying out fund of hedge fund fees, you want to rely on more than the fund's marketing brochure.