The single-manager and multi-manager approaches to investing in private alternative investment funds each have their own sets of pros and cons. Single-manager funds, for instance, tend to have lower fees and no “netting risk,” but added “dispersion risk.” Multi-manager funds offer instant diversification and built-in due diligence, but often have higher fees since there are two levels of management, plus “netting risk.” These and other issues are explored in the September 2015 white paper by Steben & Company, Single Manager vs. Multi-Manager Alternative Investment Funds.
Alternative strategies typically have a higher level of dispersion between the best and worst managers than other asset classes. Thus, investing in a single alternative fund managed by a single manager runs a greater risk of significantly underperforming the category average, than would investing in several single-manager funds or a single multi-manager fund.
Interestingly, single managers who perform in the top quartile for a given year are nearly as likely (26%) to be in the bottom quartile the following year as they are (27%) to be in the top quartile again. This means due diligence must go well beyond picking the top performers from the previous year.
Dispersion risk may be mitigated by investing in several single-manager funds, but that requires yet another level of due diligence. Picking managers at random is unlikely to enhance performance, and if an investor’s goal is to beat the category average, this objective is undermined as more managers are added to the basket and it begins to resemble the category average.
Multi-manager funds may seem like a better way of mitigating the dispersion risk inherent in alternative investments, but multi-manager funds have their disadvantages, too. For starters, there’s “netting risk” (which, generally speaking, does not occur in mutual funds or other funds that do not charge a performance fee).
Multi-manager funds operate as “funds of funds” (“FOFs”) with two layers of management. For starters, there’s the investment advisor, and then there are the underlying subadvisors that the investment advisor selects to manage portions of the fund. Both layers of management receive assets under management fees, and the subadvisors may receive performance fees.
Netting takes place when some subadvisors generate profits for their sleeve of the fund’s assets, and thus receive performance fees, but others lose more money for the fund, resulting in net losses. Thus, the fund ends up paying performance fees on net losses – a risk single-manager funds do not carry.
Advantages to Both
While dispersion and netting risk pose respective challenges for single- and multi-manager alternative funds, each style has its own advantages, as well – and alternatives as a whole are attractive, in the opinion of the white paper’s authors, because they offer the potential for downside protection during times of market stress.
Single-manager funds often implement one core investment strategy, and may incorporate specific themes like climate change. They have lower fees and no netting risk, and investors with the time and inclination to select several single-manager funds for each strategy may be able to outperform multi-manager equivalents, after fees.
Multi-manager funds offer diversification and built-in due diligence operations performed by a professional investment team. Yes, this comes at the price of higher fees and potential netting risk, but multi-manager funds may offer individual investors access to managers they can’t buy in a single-manager fund, such as hedge-fund managers.
For more information, download a pdf copy of the white paper.