What is the Fund of Funds (FOF)?

Funds of fund mean pooled funds on investors which are not directly invested in stocks/securities i.e., it is a portfolio which contains a portfolio of other funds also known as a multi-manager investment and they invest in hedge funds, mutual funds, Stocks, Bonds and various other types of securities. It is popularly called a Collective Investment or a Multi-Manager investment fund.

FOF Strategies

The aim of this 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.

FOF simply follows 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 the 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.

FOF management companies either invest directly into the hedge funds by buying shares or offer investors access to managed accounts that 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 the 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 the minimum investment would be $50 million (assuming a minimum $10 million investment per fund). However, if there is a Fund of a hedge fund that 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.

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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.

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 FOF Manager is a formal process that involves conducting background checks before the 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 that are already closed to new investors if the fund of the 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, 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 a quick entry and exit more difficult. However, if these techniques are used wisely, then such tactics can gift rich returns.

Funds of Funds Structure Drawbacks

A major drawback of investing in such a fund is the number 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 diversification may not necessarily be a beneficial option.

Risk of Investments in FOF

There are inherent risks applicable to hedge funds and if the FOF has invested in a particular hedge fund then risks get automatically carried on to it.

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 the pricing of its securities especially the illiquid ones. When the 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 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 FOF may be complex. There can be a 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 that 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 in the meantime. A number of studies have been conducted regarding the number of hedge funds for diversification, but the “sweet spot” seems to be around 8 to 15 hedge funds.

Also, look at Hedge Fund Strategies

Conclusion

FOF can be a pain-free entrance to a saturating hedge fund industry not promising exorbitant returns before the 2008 Financial crisis. It is relatively less tedious for investors to enter with a limited amount of funds or those who are relatively inexperienced with the handling of hedge funds. It should not be taken for granted that despite taking all such precautions, FOF would be a perfect fit for 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 as the investors’ personal investment goals, risk tolerance, and time horizons.

Fund of Funds (FOF)