Last time, we looked at what funds of funds (FoFs) are, and the two most common approaches: multi-strategy and multi-manager funds. Today, we’ll look at the overall advantages and disadvantages of the category.
Advantages
Relatively low minimum investment levels. A fund of funds does not have to limit itself to accredited investors (investors with a net worth of more than $1 million or an annual income over $200,000). Many traditional hedge funds, on the other hand, prefer to have a few large investors rather than many small ones, so they often set minimum investment thresholds of $250,000 or higher. In contrast, you can invest in some fund of funds for as little as $25,000.
Diversification. With a fund of funds, investments go into a diversified portfolio of different hedge funds, which has the potential for increasing returns and reducing overall portfolio risk.
Oversight. The manager of a fund of funds is a trained investment professional who has the responsibility to perform due diligence on the individual hedge fund managers in his fund. In addition, he provides ongoing monitoring and performance measurement of the individual funds on behalf of investors.
Disadvantages of Funds of Funds
Potentially higher fees. Whether it’s a bank, broker or consultant who sets up a fund of funds, this manager usually earns a fee on top of the fees charged by the underlying hedge funds. This clearly adds an additional layer of costs to investing in FoFs. So much so, that there’s an industry joke referring to them as “fees of fees funds.” A 2002 survey by UBS revealed that typical fund of funds management fees were roughly 1% of assets, with an incentive of up to 10% on capital gains.
Limited redemption rights. As with some hedge funds, an investor in a fund of funds may be limited to when and how much money he can withdraw. Some funds of funds have “gates” and “lock-ups” on investor cash. Lock-ups are periods during which investors must commit their money. Lock-up periods can last several years. Gates are limits on the percentage of capital an investor can withdraw on a particular redemption date. Both gates and lock-ups limit an investor’s ability to redeem or cash in his investment. Hedge fund managers use gates and lock-ups to protect against a stampede of redemptions that could destroy their fund, something we’ve seen in the recent market crash, where some hedge funds suffered massive redemptions.
Complex tax structure. Hedge funds are set up as partnerships, with each investor a limited partner in the fund. Thus, each partner is responsible for a proportionate share of the profits and expenses. And each investor has to pay taxes on capital gains, even if they won’t receive any cash until they exit the fund. A fund of fund therefore adds another layer of complexity on top of this, given that a fund of funds aggregates the profits, expenses and taxes owed from each hedge fund in the fund.
Transparency. You must rely on the fund of fund’s manager’s talent and expertise to research the background, reputation and track record of the underlying hedge fund managers. You are dependent on this manager’s expertise to choose managers wisely and keep you informed on the status of each fund.
A Popular Choice
Funds of funds can be a good entry point into the world of hedge fund investing for investors with limited funds or limited experience. In the past 10 years, more and more investors are gravitating toward funds of funds, and they are creating more hedge fund jobs.
In fact, assets under management for funds of funds have grown faster than for all other types of hedge funds. Funds of funds provide diversification among managers, professional oversight, reduced risk, and the potential for higher net returns than the average hedge fund. Given the recent volatile economic environment, many investors will find the security provided by funds of funds quite attractive.
References:
Logue, Ann C. Hedge Funds for Dummies: A Reference for the Rest of Us. Wiley Publishing.
Jaeger, Robert A. All About Hedge Funds: The Easy Way to Get Started. McGraw-Hill.
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