Do Funds of Hedge Funds Add Value? Evidence from their holdings!!

We examine the value of fund of funds (FoFs) using a new database of the funds’ hedge fund holdings. This data allows a first ever look at the types of hedge funds that FoFs select, as well the ability to gauge the FoFs’ skill at hiring and firing hedge fund managers. We find that FoFs hire larger, younger, and more illiquid hedge funds that have positive past performance. FoFs select hedge funds with complementary contract features to their own (e.g., liquidity.) However, we are unable to detect skillful fund selection by FoFs. The hedge funds selected by FoFs significantly outperform their peers prior to being hired by a FoF. After they are hired however, these hedge funds perform no better than comparable funds. The lack of skill in hedge fund selection suggests FoFs add value through other channels. We find evidence that one of the primary sources of value added by FoFs comes via skillful monitoring of their underlying hedge fund investments. Specifically we find that hedge funds fired by FoFs subsequently perform significantly worse than other hedge funds. Additionally funds that are held by FoFs are less likely to fail. The hazard rate for hedge funds held by FoFs is 57% lower than other comparable hedge funds, and funds fired by FoFs have a 25% greater likelihood of failure than other funds.