The hedge fund of funds (FoF or HFoF) has become an appealing avenue into hedge funds for many investors.
Simply put, it is an actively managed portfolio of hedge funds. The investor hires a third party to perform all aspects of hedge fund due diligence. Investors do this for a number of reasons. First, the due diligence process is complex and expensive. You need knowledge, experience and access to hedge fund lists.
As a portfolio manager, FoF’s also involves a bit of career risk—if you choose the wrong funds, you might lose your job. Another reason is to get diversification. An FOF usually invests in a number of strategies, the returns of which are often historically non-correlated (a benefit). Further, an investor can get access to the top hedge funds.
Some FOF managers have very good relationships with fund managers, and can invest in them while others find themselves locked out. Smaller minimum investments are an additional appealing aspect. However, due to some fraud cases and “blow-ups,” some investors have begun to doubt the due diligence capabilities of FOFs. They may create their own portfolio of funds, or may be more comfortable with a registered, “hedge-like” mutual fund.
The above benefits come at a cost. A hedge fund of funds will charge a management fee (and sometimes an incentive fee) to perform this service, over and above the fees charged by the underlying hedge fund managers. Also, since it is difficult to understand all of the FOF’s underlying strategies, the investment is usually a matter of trust. And, the relatively short track record of many FOFs makes developing trust somewhat difficult.
A Disadvantage of Funds of Funds
Potentially higher fees. A 2002 survey by UBS revealed that typical fund of funds management fees were roughly 1% of assets, with an incentive of up to 10% on capital gains.
Whether it’s a bank, broker or consultant who sets up a fund of funds, the manager usually earns a fee on top of the fees charged by the underlying hedge funds. This clearly adds an additional layer of costs (which investors are increasingly weary of) to investing in FoFs. In fact, there’s an inside industry joke referring FoF’s as “fees of fees funds.”
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