Hedge Fund of Funds
Hedge fund of funds are investments that invest in other hedge funds. Hedge fund of funds provide opportunities for increased diversification, access to highly desirable funds, and fund selection and monitoring expertise. However, hedge fund of funds include a double layer of fees, dramatically reducing the investments’ appeal.
Hedge fund of funds allocate contributed capital between a variety of hedge funds. Normally, a portfolio of 15 to 25 different hedge funds is used. Many, but not all, hedge fund of funds are register with the SEC, and have lower minimum investments (normally $25,000-100,000) then traditional hedge funds. In addition, funds registered with the SEC must provide quarterly reports and a prospectus.
Advantages
Hedge fund of funds have certain advantages that have contributed to the industries dramatic asset growth. The three main advantages are increased diversification, due diligence, and access to highly desirable funds.
Hedge fund of funds provide an opportunity to invest in a diversified portfolio of hedge funds. Institutional managers of hedge fund of funds attempt to create the optimal grouping of hedge funds, providing enhanced diversification and reducing risk. Because the hedge fund industry is characterized by limited disclosure, utilizing industry experts to create a diversified hedge fund portfolio is an important advantage.
Another key advantage is increased due diligence. Because the hedge fund industry is subject to fewer regulations and disclosure requirement then the mutual fund industry, analyzing hedge fund and hedge fund portfolios can be difficult for average investors. In addition, many of the investment strategies employed by hedge funds are very complicated. These factors cause the necessary due diligence required to assemble a diversified portfolio of quality hedge funds to often be too time-consuming for individuals. Hedge fund of funds provide investors with access to industry due diligence expertise.
Hedge fund of funds can provide individual investors with access to highly desirable hedge funds. Most high-quality hedge funds either have very high minimum investment requirements or are closed to new investors. Occasionally, slots in these funds open. These slots are usually allocated to institutions, such as hedge fund of funds. Hedge fund of funds provide a way for individual investors to access these funds.
Disadvantages
The dramatic disadvantage of hedge fund of funds is the expenses. Individual hedge funds normally have a two twenty fee structure. This means that the hedge fund has a two percent expense ratio and then charges a twenty percent management performance fee. Hedge fund of funds also have fees. Many hedge fund of funds will charge an additional 10% fee. Because of this, hedge fund of fund investors are subject to a double layer of fees. These expenses can have a dramatic adverse impact on long term returns.
According to business week, the average hedge fund of fund had an annualized return of 6% over a four year period ending March 31, 2006. The S&P 500 had an annualized return of 7.25% over the same period. While the risk levels of these investments may be different, this example illustrates the adverse impact of high fees compared to a common benchmark.
In addition, hedge fund of fund investors are subject to manager risk. The investor relies on the fund of fund manager to choose the correct hedge funds and asset allocation. Sometimes managers make incorrect decisions.
Conclusion
The hedge fund industry offers exposure to unique investment strategies and talented managers. However, limited disclosure and high minimum investments impair the ability of most investors to intelligently select a diversified hedge fund portfolio. Hedge fund of funds fill this need.
However, investors pay a huge price for this service. I think that the dramatic expenses of hedge fund of funds is a key limiting factor. I believe that the average investor would be better suited investing in a low cost, diversified portfolio of mutual funds and staying the course for the long-term.
Related Sites:
Fund of hedge funds- Market trend analysis (PDF)
SEC: Hedging Your Bets: A heads Up on Hedge Funds and Funds of Hedge Funds
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