5. hedge fund of funds
A hedge fund of funds, sometimes called a "multi-manager hedge fund", is a hedge fund where the manager invests in a "basket" of individual hedge funds and does not directly trade or invest in equities, bonds, currency or other instruments. The underlying hedge funds may be a mixed basket of the investment strategies described in the previous sections (diversified by strategy, market and manager), or may be of a single investment strategy type (diversified by manager and market). Because investors' capital is diversified among several different hedge funds, a hedge fund of funds ideally exhibits lower risk and volatility than an individual hedge fund.
The hedge fund manager I recently met in Japan is a hedge fund of funds manager. He was in Japan meeting with Japanese hedge fund managers and doing his due diligence on their performance; that is possibly the single biggest advantage of investing in a reputable hedge fund of funds with a hard working and diligent manager. The fund manager is constantly traveling the world doing face to face due diligence on managers of hedge funds of varying sizes, varying volatilities, varying returns, varying histories, and varying investment styles and strategies. The hedge fund of funds manager then invests in those hedge funds which, according to his/her personal investment "algorithm", he/she believes will create a uniquely diversified hedge fund that will provide a more stable return with minimized risk than would an individual hedge fund.
A hedge fund of funds can be registered with the U.S. Securities and Exchange Commission further to the Investment Company Act of 1940 and, if registered for sale to the general public under the Securities Act of 1933, can be offered to an unlimited number of investors, often with much lower minimum investment requirements (sometimes as low as $25,000) than is often the case with individual hedge funds which may require a minimum investment of $1,000,000 or more.
Because of its diversified risk and more predictable returns, the hedge fund of funds is often the hedge fund investment of choice for pension funds, endowments, insurance companies, private banks, high net worth individuals and family offices.
The main benefits of an investment in a hedge fund of funds are:
- a diligent hedge fund of funds manager constantly meets and evaluates different individual hedge fund managers and acquires a level of insider knowledge generally unavailable to individual investors,
- it provides an investment portfolio with an easily administrated single investment in a diversified basket of generally unrelated hedge funds with diversified investment styles, strategies and managers,
- it can be widely diversified, or focused on a specific sector, investment style or geographic region,
- it tries to deliver more consistent and predictable returns at lower risk than comparable investments in individual hedge funds,
- it can provide a much lower degree of correlation (or even be totally unrelated) to the performance of bond and equity markets,
- it reduces through diversification the discretionary trading judgment risks inherent in individual hedge funds where discretionary trading authority is exercised by a single fund manager,
- it reduces administration costs and time substantially when compared to the effort required to evaluate, monitor and administrate the number of direct investments in individual hedge funds necessary to achieve the same potential benefits,
- it provides access to a diversified portfolio of leading individual hedge funds, each often managed by the premier fund manager in his/her sector, for a low minimum investment when compared to the aggregate value of the minimum investments required to directly invest in each individual hedge fund.
Of course the hedge fund of funds also has potential disadvantages:
- a hedge fund of funds incurs multiple management fees (although being part of the spread on the units' price they are usually transparent to investors) because management fees and performance fees are charged by the manager of each individual hedge fund and the hedge fund of funds manager will also charge a management fee (and of course possibly a performance fee),
- a hedge fund of funds, even if registered with the U.S. SEC or traded on some other regulated exchange, generally invests in a basket of hedge funds which are individually not subject to any regulatory requirements and which do not therefore have the normal investor protections common to most traditional registered investments,
- because the individual hedge funds within a hedge fund of funds are not regulated, there is no guarantee of transparency (or fidelity) of information and it may be difficult for the hedge fund of funds manager to properly assess an individual hedge fund's performance or to verify information that it reports,
- the hedge fund of funds manager exercises sole discretionary investment authority over the fund and may rely upon unconfirmed, unaudited or inaccurate data when performing due diligence on the underlying hedge funds and their managers; if he/she makes errors of judgment the fund will suffer proportionately,
- a hedge fund of funds, whether registered or not, is often an illiquid investment which:
i.e. you may not be able to get your investment back when you want,
- may be subject to restrictions on transferability and resale,
- is not bound to follow any specific rules on pricing,
- may not be redeemable at the investor's option, and,
- may not have any secondary market for the sale of its units,
- the tax structure of a hedge fund of funds may be complex and cause delays in issuing of tax information necessary for filing your income tax return.
6. Hedge fund index of terms >>