Hedge funds once catered to the ultra-wealthy and required “qualified investors” with $1 million in net worth or $250,000 or more in liquid assets to invest, as a minimum. As the category became more competitive and saturated, hedge fund managers sought creative ways to bring in funds from the merely affluent. One way to do this was to create “funds of hedge funds”, register them with the Securities and Exchange Commission (SEC), and dangle the carrot of lower minimum investment thresholds in front of investors who fell into the “affluent” category.
So a fund of funds is an investment pool that invests in several different hedge funds at the same time, to try to maximize potential returns or reduce risk. It is typically used by investors who have fewer investible assets to devote to hedge funds, thus a more limited ability to diversify within the category, and those who may not have as much experience investing in hedge funds.
Diversification and Professional Management
Since investing in hedge funds can be a high risk strategy (though not always), some investors choose to invest in a diversified portfolio – a fund of funds – that encompasses multiple hedge fund managers. Funds of funds can have as few as 3 or 4 managers, or as many as 20.
Like mutual funds, funds of hedge funds provide diversification and professional management for investors who do not have the time, expertise or resources to manage a many different hedge fund investments.
However, diversifying among so many managers does make the job of selecting managers, due diligence on their track records, managing assets and monitoring the performance of each manager that much more difficult. So in addition to diversification, funds of funds offer a single “manager of managers” who provides these services – for an additional fee on top of what the individual hedge fund managers charge. This fee may be based on overall assets managed, or a combination of that fee plus some performance-based incentive.
In recent years, major brokerage firms have become involved in operating fund of funds. They will often build a multi-manager fund that can have as many as 20 or more hedge funds in the portfolio, to offer to their institutional and wealthy clients. Whereas hedge funds use a prime brokers to facilitate the trading of securities, in this case, the prime broker is actually the client, hiring hedge fund managers.
Fund of Funds Strategies
Fund of funds managers usually follow one of two distinct approaches: multi-strategy or multi-manager.
Multi-Strategy
As the name suggests, a multi-strategy manager uses different hedge fund strategies in an attempt to increase returns for an established level of risk. This type of manager will try to choose hedge funds that complement one another. For example, he may choose funds that all have a directional element (i.e., have exposure to some market risk), but use different sub-strategies.
Multi-Manager
A multi-manager fund of funds invests in several hedge funds that all follow a similar strategy, but use different managers. For example, the manager may invest in absolute-return funds as the overall strategy (hedge funds that attempt to hedge away market risk and earn positive returns in any type of market). By investing in several funds within the same overall strategy, the fund of fund reduces the risk that any single hedge fund manager can have on the overall performance of the fund. The goal of the multi-manager fund is to combine the expertise of several hedge fund managers following the same strategy, to get a more consistent return from a particular strategy.
Next time, we’ll look at the advantages and disadvantages of investing in funds of funds.
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