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What is a Fund of Funds? (part 1)

Fund of Funds are individual investment partnerships that are made up of investments into multiple different underlying hedge fund partnerships. A majority of the assets under management in the alternatives industry is under the management of fund of funds. Hedge Funds have traditionally been structured as private investment partnerships, where the underlying general partner or investment advisor implements a single strategy to generate alpha. The first hedge fund was started in 1949 by Alfred W Jones. Mr. Jones was the first person to employ the use of leverage and short sales to generate returns. He then proceeded to convert his general partnership into a limited partnership, thereby allowing him to invest into additional portfolio managers. Essentially creating what is known today, a fund of hedge funds.

Hedge Fund of Funds Types

There are two main types of Fund of Funds.

• Single-Strategy Fund of Fund
• Multi-Strategy Fund of Fund

There are two main types of fund of hedge funds. The first would be a single-strategy fund of hedge funds. These were set up to gain access to the best managers of a single-strategy, and gain the diversification benefits of not being exposed to any one manager, while having the strategic allocation to one individual strategy. For example, a long-short fund of funds, comprised of a mix of different long-short Hedge Fund managers. The FOF manager would select the minimum and maximum amount of capital to each manager, and each underlying fund would fit the definition of a long-short hedge fund. If any of the underlying managers were to deviate from their long-short strategy, it would be known as style drift. Most limited partnerships agreement clearly define what strategy a manager is able to employ, so make sure you consult legal advice when reading your docs. For example, a long-short single strategy fund of funds, should not have any manager that is invested into real estate. Conversely, a single strategy real estate fund of funds, should not be invested into any long-short managers.

The second type of fund of hedge funds, is what is known as a multi-strategy fund of funds. This is the most traditional and most common offering today. Each manager has a proprietary mix of funds, or a proprietary mix strategy allocation decisions. There isn’t a minimum or maximum, 1. amount of different strategies and/or 2. amount of managers allocated to. The partnership is attempting to gain the benefits of diversification and obtain a mix they believe to be generating the highest returns. The mix, or allocation to different managers, may be in any combination or form decided by the general partner. Thereby allowing the manager to create a product that could have a market neutral, arbitrage, long-short, fixed income, options, commodities, and/or real estate mix. A general rule of thumb for a multi-strat fund of funds, is to have a good up-capture in periods of rising market prices and avoid the large drawdowns during periods of market price deterioriation.

In the next article I will address the benefits and disadvantages of each type of fund.

Part 2: The Advantages and Disadvantages of Funds of Funds
Part 3: Hedge Fund Service Providers

This article was written by:

Ryan Conner, CAIA
HedgeCo Networks
rconner@hedgeco.net

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