A Fund of Funds, by definition, is a fund that invests in other hedge funds, rather than in individual securities. Any fund that pools capital together, while utilizing two or more sub managers to invest money in equity, commodities, or currencies, is considered a Fund of Funds.
Investors allocate assets to Fund of Funds products mainly to diversify amongst the different managers’ styles, while attempting to minimize risk exposure.
Funds of Funds, which are structured as limited partnerships, afford several advantages to the investor. One advantage to Fund of Funds is their due diligence process. Due diligence, the time spent researching and interviewing different managers, can be very time consuming and expensive to the average investor. As a result, the Fund of Funds manager assumes this responsibility on behalf of his or her investors.
Funds of Funds also offer the advantage of diversification because they spread their capital amongst a variety of different managers, all of whom employ a unique investment strategy. Thus, it is possible for a Fund of Funds investor to gain exposure to a long/short fund, a distressed fund, and a private equity fund, all through one investment vehicle!
Funds of Funds have some drawbacks and risks, however. One drawback is the double layer of fees. When dealing with funds of funds, an investor must understand that the underlying hedge fund charges a fee, as well as the fund of funds manager. This translates into “layers” of fees which may dramatically affect investor returns.
A second potential risk stems from the due diligence process. Research, which can range from the individual manager’s background and reputation, to the nature of the investments that they are utilizing, are all issues a fund of funds manager must investigate. Therefore, although the investor is paying a manager to conduct research on a fund’s investments, the investor is also 100% dependent on the fund of funds manager’s talent and expertise in choosing managers. Hence, fund of funds investors should only invest in a manager they trust and believe in.
Funds of funds provide an important role within the hedge fund community. Not only do they provide the benefits of in-house due diligence, but they also offer a unique layer of diversification to the high net worth investor.