Investing in “Fund of Hedge Funds” Explained

Hedge funds have gained popular attention of private and institutional investors in last two decades, given their strong absolute and risk-adjusted performance (high sharpe ratio) since the early 1990s.  A hedge fund can be thought of as a private pool of investment capital that have very few restriction to invest in different asset classes and using different investment strategies to earn a high absolute return, unlike traditional mutual funds.  It was recently estimated that there are around 10,000 hedge funds with approximately $ 1 trillion assets under management.  Some investors argue that hedge funds are less risky investments than a diversified portfolio of common stocks, while others argue that may not be the case by quoting the collapse of a hedge fund in the late 1990s called Long Term Capital Management that was run by Nobel Prize winners.  As investors it would be more beneficial to diversify their exposure to different funds that follow different strategies, but it comes with an extra cost to professionally manage your investment in a portfolio of hedge funds.  The benefits of choosing the best hedge fund and earning high absolute returns can be realized by hiring a fund of hedge fund to manage your assets.  Fund of Hedge funds is a fund that follows an investment strategy to allocate investment capital to two or more hedge funds.  Assets of different investors, both private and institutional, are commingled into this fund and later invested by the professional managers in a variety of superior performing hedge funds.  The mechanism of a fund of hedge fund can be seen in the figure below.
 

Fund of Hedge Fund Mechanism

The number of fund of hedge funds and the assets held under management has grown with a significant pace.  The annual growth rate of the asset of fund of hedge funds has grown at around 48 percent since the 1990s, when compared to the hedge fund industry it is 26 percent.  In this article, we would be looking at some of the benefits and costs of investing in hedge funds.    

Advantages:

Diversification:  A fund of hedge funds provides diversification benefits to investors by investing their investment capital in large number of hedge funds.  This diversification benefit provides exposure to different successful investment strategies and sub strategies and various asset classes.  If not for a fund of hedge fund, small investors would not be able to derive this benefit because of the private nature of hedge funds.  Hedge funds would require large sums of investment capital that ranges from a half a million dollar to almost twenty five million, which makes it impossible to invest directly in a number of funds with limited investment capital.  Fund of hedge funds have been attractive to both individual and institutional investors by saving time from performing due diligence and research on different hedge funds, while performance and strategy information of these funds is sometime not even made available to potential investors.   The main idea of investing in a fund of hedge fund is not to put all the eggs in one basket, but to diversify into a diverse pool of funds to protect one’s wealth from few unsuccessful strategies.

Due Diligence:  Due diligence is a process in which fund of hedge fund staff professionally gathers all the required information about the hedge fund manager, investment strategies, and then evaluates results before investment is made.  The fund of hedge fund staff with their expertise, put in a good amount of time, resource, and effort to performs due diligence on hedge fund managers before selecting funds from an investment universe of thousands of hedge funds and also perform this activity on an ongoing basis once investment is made in a particular fund.  Some of the functions that a fund of hedge fund performs in due diligences are reading the fund’s prospectus, understanding how the hedge fund performs valuation of its assets, researching more about the fund’s fee structure, and researching on the background of hedge fund managers.  It would not be cost beneficial to individual investors to perform the above task by themselves at the expense of time and resources.

Risk Management:  One of the important benefits of investing in fund of hedge funds is that one gets to hire professionals to manage and monitor risk of your investments in this alternative investment asset class.  While fund of hedge funds invest in a variety of fund with different strategies and sub-strategies that are exposed to different risk, it becomes vital to monitor and manage the different risks.  Some of the risks that hedge funds are exposed to are: corporate event risk, equity market risk, small firm risk, efficiency risk, liquidity risk, credit risk, foreign exchange risk, and extreme event risks.   The fund of hedge funds actively monitor the risks of each kind of hedge fund, but also the risks of the total portfolio and therefore make decisions on which hedge fund to invest or divest in.  The term hedge does not mean that all hedge funds are perfectly hedged or are not exposed to any risks.  We can learn from what happen to Long Term Capital Management, a hedge fund managed by Nobel Prize winners, which collapsed in the late 1990s.  Therefore monitoring and mitigating risks should not be ignored in the process of earning highest absolute returns.

Managing Portfolio through Manager Selection and Strategy Selection:  Fund of hedge funds try to earn the highest absolute return over the average return of hedge fund industry by actively selecting best performing managers and selecting successful strategies.  So fund of hedge funds overweight their portfolio with the best performing funds or strategies and underweight the portfolio with underperforming strategies and funds to earn an alpha or excess return.

Access to Funds:  Most hedge funds are private funds and do not make information available to the public and have restrictions on what kind of investors can invest in.  And most of them do have limitation on minimum amount funds that needs to be invested in and are also closed to new investments.  If a small investor would like to gain access to 5 different funds, he would not be able to put in enough cash to meet the limitations of different funds.  But by the help of fund of hedge funds that pools funds of a large number of investors, this kind of diversification is made available.

Disadvantages:

Fund Fees:  The management fees charged by a fund of hedge funds are viewed as one of the major disadvantage by many individual and institutional investors.  According to the survey conducted by Alternative Investment Management Association, on average a fund of hedge fund charges a management fee around 1.3 percent and that can go up to a maximum of 3 percent. In addition, they also charge performance fees based on the performance of the fund, which usually ranges from 10 percent to 50 percent.  One has to make a note that the benefits that we have discussed earlier also come with a cost.

Exposure to Cash Inflows and Outflows: A fund of hedge funds like a mutual fund, pools funds of all investors to invest in multiple hedge funds.  These funds being a pool of investment capital are exposed to cash inflows and outflows that result from new investment and divestment from the fund.  Therefore, it forces the fund management to maintain a certain percentage of the investment capital in cash to honor the redemptions. This makes it impossible for the fund to reap the benefits of investing 100% of the capital into investment assets to earn a return.  Even if one investor stays invested for long time, he is exposed to activities of other investors.

Lack of Customization: Like discussed earlier that fund of hedge funds commingles fund of different investors and invests with an objective of earning highest absolute returns.  Some investors may not find it beneficial to stay invested in a fund that is like one size fits all.  Therefore, it would be beneficial for an individual investor to invest just a part of the total portfolio in this investment asset class.
 
In is essential for an investor to know the benefits and drawbacks of the different investment opportunities that are available to them.  Although investing in a fund of hedge fund is beneficial, it might not be suitable to all investors with a different risk profile.  It is recommended to consult with a financial advisor before making investment decisions.