Funds of Funds – Complete Guide | Structure | Strategies | Risks

Fund of Funds

A fund of funds (FOF) is an investment strategy in which there is a Master fund investing in various other kinds of funds. This strategy involves investing a Portfolio that contains different underlying assets rather than direct investment in Stocks, Bonds and various other types of securities. It is popularly called a Collective Investment or a Multi-Manager investment fund.

In this article, we discuss Fund of Funds in detail –

Fund of Funds Strategies


The aim of the Fund of Funds (FOF) strategy is to achieve Appropriate Asset Allocation and Broad Diversification with investments in a variety of fund categories which are all culminated into a single fund. Such funds are attractive to small investors who are open to wider exposure categories with fewer risks in comparison to direct investment in securities. This gives them a level of comfort of their principal investment not getting wiped out due to market volatility or events like counterparty default, extended inflation, recessionary pressures, etc.

Funds of Hedge Funds simply follow this by constructing a portfolio of other hedge funds which could differ depending on the investment strategies respective funds have applied. A portfolio manager uses his or her skill and experience for selection of the best underlying hedge fund based on Past performance and other relevant factors. If the manager is talented, this can increase return potential and decrease risk potential.

Fund of Funds Example

source: bdc.ca

Fund of Hedge Fund management companies either invest directly into the hedge funds by buying shares or offer investors access to managed accounts which mirror the performance of the hedge fund. Segregated or Managed accounts have grown in popularity since they provide investors with a Daily Risk reporting and helping to protect the assets of investors if hedge fund goes into Liquidation.

With such funds, there is an additional benefit given that most of the other hedge funds have prohibitively high minimum initial investments. Through, such a fund structure, investors can theoretically gain access to some country’s best hedge funds with a relatively smaller amount of investment. For e.g. if an investor desires to invest in 5 hedge funds to diversify its risk portfolio, then minimum investment would be $50 million (assuming a minimum $10 million investment per fund). However, if there is a Fund of hedge fund which invests in the underlying of all 5 such funds then the investor can have access to the benefits of all the funds with an investment of $10 million. If the fund is managed efficiently, it could even charge further less amount of investment.

This amount can be adjusted depending on the variety and number of the funds in which the investments are going to be made. The skills of the fund manager are very important in deciding the number of funds in which diversification has to be made. It is a very dynamic activity since constant monitoring is essential for all funds and industries.

Funds of Hedge Funds Structure Benefits


There are some critical benefits in addition to the above points offered by such a structure:

  • Hedge funds can have a tendency to be very opaque regarding their asset classes and their strategies. A FOF serves as an Investor’s Proxy responsible for performing due diligence, Manager Selection and oversight of the hedge fund within its portfolio.
  • The due diligence of the Fund of Funds Manager is a formal process which involves conducting background checks before selection of new managers. An in-depth investigation is executed for searching the disciplinary history of the manager with the securities industry, researching their backgrounds, verifying their credentials and checking references of the individual who desires to be Manager of FOF.
  • Such funds may be able to allow investors into funds which are already closed to new investors if the fund of fund already has cash placed with a particular manager.
  • One can also have the institutional advantages as one can make investments in various funds which are in other ways off-limit for the retail investors.
  • With careful use of leverage and short selling techniques, hedge fund returns can amplify against a declining market. Short positions can lose an unlimited amount of money, while leverage can magnify the losses making quick entry and exit more difficult. However, if these techniques are used wisely, then such tactics can gift rich returns.

Funds of Hedge Funds Structure Drawbacks


A major drawback of investing in such a fund is the amount of Fees charged. In addition to the Management Fees (around 1.5%-2% of the Assets under Management) and Incentive Fees (15%-25% of the Assets), such funds charge an “Incremental Fee”. It is widely argued, that the structure of such incremental fees is relatively larger than Potential higher Risk adjusted returns offered by the FOF. For e.g. the manager is entitled to receive 10% of any annual gain exceeding 8% risk adjusted return or the Alpha. Since it will invest in a number of private funds, the FOF also bears part of the fees and expenses of those underlying hedge funds as well.

  • Since hedge funds are not necessarily required to be registered with the Securities & Exchange Commission (SEC), the investors can become defensive in their approach. Hedge funds are typically sold in Private offerings which means they are not publicly reported like Mutual funds. Such comparison may reduce the benefits of a FOF over Mutual Funds.
  • The aspect of Diversification can be a double edged sword whereby a mixture of various kinds of hedge funds may reduce an investor’s exposure; however investors will be subject to higher fees but volatile returns. Hence too much of diversification may not necessarily be a beneficial option.

Risk of Investments in Fund of Funds


There are some inherent risks applicable to hedge funds and if the Fund of Funds has invested in a particular hedge fund then risks get automatically carried on to the Fund of Hedge Funds.

  • Lack of Liquidity: Hedge funds whether registered or unregistered are investments difficult to be converted into cash in addition to possible restrictions on its transfer or re-selling ability. There are no fixed rules on pricing of its securities especially the illiquid ones. When price of a security is not available, its value may be calculated on the basis of either price available by Bloomberg data or at cost. Registered units of the hedge funds may not be redeemable at investor’s discretion and perhaps there is no established secondary market for the sale of such hedge fund units. In simple words, one may not be able to exit the investment at the desire of the investor.
  • Adverse Tax Consequences: The taxation structure of registered Fund of Hedge Funds may be complex. There can be possible delay in receipt of important information pertaining to tax payment which in turn will delay the filing of income tax return process.
  • Over- Diversification: A FOF needs to co-ordinate its holdings else it will not add value. If not vigilant, it may unintentionally collect a group of hedge funds which duplicate its various positions or could represent sub-standard quality in relation to the rest of the market. Multiple individual hedge fund holdings with the aim of successful diversification are likely to reduce the benefits of dynamic management, despite executing the double-fee structure at the meantime. A number of studies have been conducted regarding the number of hedge fund for diversification, but the “sweet spot” seems to be around 8 to 15 hedge funds.

Also, look at Hedge Fund Strategies

Funds of Funds Current Scenario


The year 2016 has not been a very promising one for the entire hedge fund industry since the World economy especially USA is struggling with almost stagnant level of growth and consistent level of unemployment.

Fund of Hedge funds has lost more than $100 billion in the past 12 months due to underwhelming performance and consistent exit of investors. These funds are not in a position to offer lucrative returns in contrast to the risks which they are bearing. Clients have pulled out in excess of $50 billion in the past 1 year while Investment Managers have posted an Average of $51.5 billion of Investment losses in the same time frame. Net assets in the sector have also shrunk by 11% to $841.6 billion, which has been the lowest since the 2008 Financial Crisis.

Certain hedge funds are also attempting to lure more investors by charging lesser fees but it is not yielding any results as yet.

Below is a snapshot of The Barclay Fund of Funds Index which is a measure of the average return of all the FOF’s in the database of Barclays.

fund of hedge funds

source: barclayhedge.com

The above chart gives an indication of how all of their Fund of Funds are performing based on their investments in various categories of hedge funds. It can be seen that the year of 2016 has been very difficult considering the slowness of the global economy. The returns in positive are not as attractive but the downfall seems to be significantly visible.

It is also observed that when a  invests in a hedge fund it does have an impact on the overall statistics of the entire industry. Fund of Hedge Funds investors tend to use all possible strategies in the hedge fund industry in order to get a definite source of “Alpha” in all possible economic scenarios. In addition, long/short equity managers tend to have a variable bias, making net exposure management tougher at the fund of funds level.

Fund of Hedge Funds

hedge funds strategies

The above snapshot is an indication of how a FOF makes a selection of funds with various strategies. In this case, the FOF’s are making more investments in funds which adopt Arbitrage strategies in order to take advantage of the Price and Time difference between 2 markets. FOF’s are also inclined to make investments in funds which are inclined to take advantage of specific events which can have an impact on the overall performance. For e.g. ABC Hedge fund will purchase shares of CIPLA Pharmaceuticals which is expected to get a drug approval for treatment of a non-curable disease. This can rocket the share price of CIPLA due to this specific event.

Fund of Hedge Funds once aware of such possibility would like to take advantage of such a situation and may invest in ABC Hedge fund knowing its Alpha can improve substantially.

Such statistics also have an impact on the Liquidity terms of the funds with Fund of Funds investors rather than that without them. Despite all the griping from funds of funds about the liquidity terms of their underlying managers, funds with Fund of Funds investors actually seem to have slightly worse liquidity as per the below snapshot.

hedge funds liquidity

It can be inferred, that the Fund of Funds will be aggressively looking to gain higher returns from short term activities and investors may want to make quick money with limited investments and exit the fund.

Conclusion


Fund of hedge funds can be a pain-free entrance to a saturating hedge fund industry not promising exorbitant returns before the 2008 Financial crisis. It is a relatively less tedious for investors to enter with a limited amount of funds or those who are relatively inexperienced with handling of hedge funds. It should not be taken for granted that despite taking all such precautions, Fund of Hedge Funds would be a perfect fit to the appetite of the investor. An investor should carefully go through the fund’s offer documents and associated materials prior to making the investments so that the level of risk involved in the fund’s investment strategies is clearly understood. The risks undertaken should be in the same wavelength with the investors’ personal investment goals, risk tolerance and time horizons.

The role of the hedge fund manager is very critical in such a structure of fund. A  depends on the expertise and ability of the manager to select the funds which will perform in excess of what the market is offering. The background checks and the credentials of the FOF manager Fund of Hedge Funds has to be vetted very carefully since such funds have the tendency to employ underperforming fund managers so as to offer them a platform to launch their careers.

Performance fees can pursue the fund manager to consider taking greater risks with a positive attitude of generating substantially large returns for themselves and the investors. If a manager extracts a large share from the capital gains of a fund, the fund manager may take unnecessary risks to profit from the potential returns. If a hedge fund manager is very active in market trading activities, the continuous transaction activities can result in higher tax consequences than a strategy to buy and hold a particular investment. Higher taxes will reduce the overall return an investor expects to receive on their investment. In a nutshell , a good fund of hedge fund should represent less risk and the sum of its parts allowing an investor’s portfolio to accumulate value at a steady rate.

Comments

  1. By Wyatt Gordon on

    Thank you so much for giving such a informative knowledge towards funds. I was looking to expand my startup hedge fund business. Any hedge fund management tips?

    Reply

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