In the first article in this series, I gave you an overview of Fund of Funds. In this section we discuss the Benefits and Drawbacks.
Benefits of Fund of Hedge Funds
Why should I let someone else choose for me?
There are highly touted benefits to investing with fund of hedge fund managers. The first few benefits I will discuss will involve the structural and due diligence advantages. First, is the outsourcing of manager talent and selection. For the typical investor, they lack the resources, experience, tools, and connections to perform the effective due diligence required to evaluate each manager. Furthermore, the time needed to gain this expertise is very extensive and takes time to understand. By investing into a Fund of Hedges Funds, the investor is outsourcing this manager selection decision making to the fof manager. This is one of the main value-add propositions and requirements to be performed.
Second, would be a thorough due diligence evaluation. Due diligence is something that needs to be undertaken in the utmost importance. An evaluation would include examinations of the underlying managers fund structure, history, offices, and implementation. It is common practice to have due diligence questionnaires filled out, contacting each and every underlying service provider, and even conduct on-site visits with the manager. There is no limit or minimum amount of due diligence that must be conducted. However, an investor must expect that their manager is conducting the required diligence, or this would not be a value-added proposition. Also, many potential problems can be identified before any allocation is made.
Now, we get to the investment related benefits to what a fund of funds can offer. The primary and most important benefit to fund of hedge funds is diversification. As an investor in a fund of funds, you get a piece of the returns for all of the underlying managers. This reduces your exposure to any one manager. As the old verbiage goes, “It is not wise to have all your eggs in one basket.
In a multi-strategy product, reduces the exposure to any one sector through diversification. There are cyclical downtowns that can affect long-short and long biased equities hedge funds. However, it is noted that during the same periods, it would be wise to have exposure to styles and strategies that are either absolute in nature or are completely un-correlated to equities. A good example of this would be the addition to a CTA or Absolute Return type strategy (such as Merger Arb). However, this reduction is up to the discretion of the manager and the limits that are stated in the fund’s private placement memorandum (PPM) or offering memorandum (OM). Each individual fund may have a target allocation to certain strategies, with a minimum and maximum number of both strategies and number of managers. For example, a maximum allocation to any one strategy or any one manager may not top 10%.
Drawbacks to Fund of Hedge Funds
The main drawback to fund of hedge funds is what is known as the double-layering of fees. There is no requirement as to the minimum or maximum that any hedge fund may charge. They are private investment partnerships, and are therefore free to decide what is right for each partnership. One of the most common forms of fees, is what is known as the 2 and 20. This is a 2% management fee and 20% performance fee on all assets in the partnership. The fees can be paid out in any combination that is set forth by the partnership. The criticism here, is that the capital is allocated to individual managers, who charge a 2 and 20, whose returns are then sent to the fund of funds to be charged an additional 2 and 20. The capital is charged twice, and amounts to what is known as the double-layer of fees. Also, because the fund of fund manager is not really producing anything. The value proposition is that the fund of fund manager is better than the individual investor at selecting hedge fund managers, thereby warranting double-layer of performance fees.
Another drawback to fund of hedge funds is the lock-up period associated with most strategies. In an individual fund, the manager may liquidate positions much more quickly and redeem the investor when there is a request. A fund of hedge funds may have a longer wait to redeem all capital allocated, as they need to redeem the capital from all of the managers that the capital was placed with. This could prove to be troublesome due to underlying managers with illiquid strategies, such as real estate or restricted securities.
According to Evan Rapoport, CEO of HedgeCo Securities, “We have seen an increasingly larger amount of fund of funds moving towards managed account structures. After the events of 2009, investors were no longer as willing to lock-up capital in illiquid structures. Fund of Funds have been moving towards the manged account structure to provide for increased transparency and liquidity on behalf of the investor.”
A third drawback to fund of hedge funds is the over-diversification. This is possible when either the fund of funds has too much size, and/or too many underlying managers to generate a good return. The assets are invested over so many managers, that they underlying returns start to become weighted down from the performance of both good and bad performing funds. While diversification studies have generally shown there are numerous benefits, there is an argument that can be made against over-diversification.
A fourth drawback would be the inclination of investors to go towards fund of funds, just because they have large AUM’s. They feel that if the AUM is huge, they must be doing something correct. In my opinion, it is important to have a decent amount of AUM, but too much can be a bad thing. As the fund approaches 10 or 20 Billion, it is much harder to generate out-sized returns than on an AUM level of say, 1 or 2 Billion.
In the third and final segment on this article on Fund of Funds, we’ll go over Hedge Fund Administrators and Service Providers.
This article was written by:
Ryan Conner, CAIA
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