Fund of Funds Investing

CFA Level 1 - Alternative Investments

Any fund that pools capital and uses two or more sub managers to invest that capital - whether it is debt, equity, commodities, derivatives, or currencies, is a fund of funds. Any combination of the above instruments may be used depending on the objectives of the fund. Because of the loose definition of this term, a pension fund or an endowment fund can be considered a fund of funds. But for clarity, we'll concentrate on a fund of funds as it relates to other hedge funds. By its very nature, a fund of funds does not make direct investments, and it is known as a "look through" vehicle. The fund of funds manager spends considerable time evaluating and identifying strategies and selecting the hedge funds to implement them. Depending on the expertise of the fund of funds manager, this can yield superior investment results. Ordinarily, a fund of funds is structured as a limited partnership.   

Benefits:

1. Retailing - Allows an investor access to a large number of hedge funds.
2. Access - May be able to allow investors into funds that are already closed to new investors if the fund of fund already has cash placed with a particular manager.
3. Diversification - Allows investors to diversify the risk of a single hedge fund by investing in several types of hedge funds. A fund of funds can control risk by achieving manager diversity. They accomplish this by diversifying in the strategies those managers employ. To the investor, this allows them to participate in a unique asset allocation mechanism while hopefully limiting downside risk.
4. Expertise - Managers should have better knowledge and experience in picking successful hedge fund managers.
5. Due Diligence Process -This process is very time consuming and highly specialized. A fund of funds manager should be exceptionally experienced and well equipped to perform this process.

Fund of funds are not without disadvantages, however, and we would be remiss not to discuss them.

Drawbacks:

1. Fee - An investor in a fund of funds is required to pay an additional layer of fees. Usually, these fees range from 1-2% of assets, but some fund of funds charge a performance fee, too. However, the SEC limits the number of fees an investor can pay.
2. Performance - The hedge funds in the fund of funds are usually chosen by their past performance, which tends to give little indication of future performance. It is wise to remember that a fund of funds is only as good as its manager and the underlying funds it invests in.
3. Diversification is a two-edged sword - Blending various types of hedge funds may reduce your exposure; however, you'll be subject to higher fees and disparate returns.

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