Getting caught out on Amaranth was bad enough. Getting caught out again on Sowood Capital? Not great either. And with hedge funds getting hit left, right and centtre, just how many times can funds of hedge funds keep telling us everything’s alright? Arden Asset Management, to name but one fund of hedge funds, was caught out on both counts. Tremont was another. And the response that rolls off the tongues of funds of hedge funds officials whose underlying managers go bust is always the same – we spread risk by investing in many underlying managers, so the damage is limited.
Is this really the case, however? Not according to an internal memo put out by Jerome Abernathy of Stonebrook Capital. The former Moore Capital staffer turned alternative beta shop owner is quite adamant that funds of hedge funds are losing a lot more than they claim when their underlying managers screw up. For a $5 billion fund of hedge fund with a 4% allocation to an underlying manager that blows up, a total present value of losses of more than $55 million will result, and, at the most conservative estimate, half that, Abernathy calculates.
These costs come from several directions.