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.
This strategy aims to achieve Appropriate Asset Allocation and Broad Diversification with investments in various fund categories, which are all culminated in a single fund. Such funds are attractive to small investors open to broader exposure categories with fewer risks than a 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 follows this by constructing a portfolio of other hedge fundsHedge FundsA hedge fund is an aggressively invested portfolio made through pooling of various investors and institutional investor’s fund. It supports various assets providing high returns in exchange for higher risk through multiple risk management and hedging techniques., which could differ depending on the investment strategies respective funds have applied. A portfolio manager uses his or her skill and experience to select 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 LiquidationLiquidationLiquidation is the process of winding up a business or a segment of the business by selling off its assets. The amount realized by this is used to pay off the creditors and all other liabilities of the business in a specific order..
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. 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 five 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 will be made. The skills of the fund manager are critical 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.
There are some critical benefits in addition to the above points offered by such a structure:
- Hedge funds can tend 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 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 institutional advantages as one can make investments in various funds, which are, in other ways, off-limit for the retail investorsRetail InvestorsA retail investor is a non-professional individual investor who tends to invest a small sum in the equities, bonds, mutual funds, exchange-traded funds, and other baskets of securities. They often take the services of online or traditional brokerage firms or advisors for investment decision-making..
- With careful use of leverage and short sellingShort SellingShort Selling is a trading strategy designed to make quick gains by speculating on the falling prices of financial security. It is done by borrowing the security from a broker and selling it in the market and thereafter repurchasing the security once the prices have fallen., hedge fund returns can amplify against a declining market. Short positionsShort PositionsA short position is a practice where the investors sell stocks that they don't own at the time of selling; the investors do so by borrowing the shares from some other investors to promise that the former will return the stocks to the latter on a later date. can lose an unlimited amount of money, while power 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 significant 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 more massive than the Potential higher Risk-adjusted returns offered by the FOF. 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 several private funds, the FOF also bears part of the fees 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 fundsMutual FundsA mutual fund is an investment fund that investors professionally manage by pooling money from multiple investors to initiate investment in securities individually held to provide greater diversification, long term gains and lower level of risks.. 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 risksInherent RisksInherent Risk is the probability of a defect in the financial statement due to error, omission or misstatement identified during a financial audit. Such a risk arises because of certain factors which are beyond the internal control of the organization. applicable to hedge funds, and if the FOF has invested in a particular hedge fund, then threats get automatically carried on to it.
- Lack of Liquidity: Hedge funds, whether registered or unregistered, are investments challenging 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 based on 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 complicated. There can be a possible delay in receipt of important information about tax payment, which will delay the filing of the 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 represent sub-standard quality concerning 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. Several 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 StrategiesHedge Fund StrategiesHedge fund strategies are a set of principles or instructions followed by a hedge fund in order to protect themselves against the movements of stocks or securities in the market and to make a profit on a very small working capital without risking the entire budget.
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 before 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 toleranceRisk ToleranceRisk tolerance is the investors' potential and willingness to bear the uncertainties associated with their investment portfolios. It is influenced by multiple individual constraints like the investor's age, income, investment objective, responsibilities and financial condition., and time horizons.
This has been a guide to what is Fund of Funds (FOF)? Here we discuss the structure of FOF along with its advantages and disadvantages along with the risks involved. You may learn more about Portfolio Management from the following articles –