What is a Fund of Hedge Funds? Overview and Investment Approach

A fund of hedge funds (FOHF) is an investment vehicle that invests in a portfolio of underlying hedge funds. FOHFs provide investors with instant diversification and access to multiple hedge fund strategies and managers through a single investment. This article will provide a comprehensive overview of hedge fund of funds.

We’ll also explore the investment approach and due diligence process undertaken by FOHF managers when constructing their portfolios. By the end, you’ll have a solid understanding of this popular fund structure and how it provides exposure to the hedge fund universe.

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What is a Fund of Hedge Funds?

A fund of hedge funds is an investment vehicle that invests in a diversified portfolio of underlying hedge funds. The FOHF itself is structured as a fund, with investors purchasing shares that represent a portion of the FOHF’s holdings.

The FOHF manager conducts due diligence on hedge funds and allocates capital across them based on their investment strategies, performance track records, risk profiles, and operational controls. By investing through a FOHF, investors get instant exposure to multiple hedge funds through a single investment.

Some key characteristics of funds of hedge funds:

• Diversification – FOHFs provide instant diversification by investing in a range of hedge fund strategies and managers. This minimizes concentration risk.
• Access – FOHFs have lower investment minimums than individual hedge funds, making them accessible to a broader range of investors.
• Due diligence – The FOHF manager conducts operational and investment due diligence on the underlying hedge funds, providing an added layer of oversight.
• Professional management – FOHF managers are experienced investment professionals that construct portfolios, manage allocations, and provide risk management.

In exchange for providing these services, FOHF managers charge an additional layer of fees on top of the fees charged by the underlying hedge funds.

Overall, a FOHF offers a convenient way to invest in hedge funds and aims to provide portfolio diversification and improved risk-adjusted returns over the long run. The FOHF structure pools investor capital to provide buying power and access to top-tier managers that may otherwise be restricted to large institutional investors.

How Do Funds of Hedge Funds Work?

Funds of hedge funds have a multi-layered structure that provides investors with diversified exposure to many hedge funds through a single investment. Here is an overview of how FOHFs work:

Investors – Individuals and institutions invest capital into a FOHF by purchasing shares. The FOHF manager pools this capital and invests it into their portfolio of hedge funds on behalf of investors.

FOHF Manager – The FOHF manager is responsible for portfolio construction, manager selection, due diligence, allocation, risk management, and operations. The manager charges a management fee and performance fee.

Underlying Hedge Funds – The FOHF invests in a diversified portfolio of hedge funds across various strategies, managers, and geographic regions. Each underlying hedge fund charges its own fees and may have incentive fees.

Hedge Fund Strategies – Hedge fund managers employ various strategies including long/short equity, credit, distressed debt, macro, arbitrage, relative value, and more. Allocating across strategies enhances diversification.

Due Diligence – Through investment and operational due diligence, the FOHF manager assesses hedge funds on their track records, infrastructure, risk controls, talent, and overall ability to add value for investors.

Portfolio Construction – The FOHF manager combines hedge funds based on their risk/return profiles, correlations, and role within the portfolio to target the desired level of return and risk. The allocation across funds will be actively managed.

Risk Management & Monitoring – The FOHF manager monitors the portfolio’s risk metrics, liquidity, and performance attribution. They may rebalance the portfolio as needed. Underlying hedge funds are monitored for style drift and risk changes.

Liquidity Terms – FOHF shares usually have quarterly or monthly liquidity. The underlying hedge funds often have less frequent dealing terms that are matched to the liquidity offered to FOHF investors.

This multi-layered structure provides investors with professional management and diversification across hedge fund strategies and managers in a package that offers superior liquidity through a single investment.

What are the Benefits of Investing in a Fund of Hedge Funds?

There are several major benefits that FOHFs offer investors:

1. Diversification – The primary benefit is instant diversification across strategies, managers, and market sectors and factors. By investing through a single well-constructed FOHF, investors can gain exposure to a wide range of approaches that enhance portfolio diversification.

2. Access – Many top performing hedge funds have high minimum investments and only accept institutional capital. FOHFs provide access to high-quality managers with lower investment minimums by pooling capital.

3. Due Diligence – Given the opaque nature of the hedge fund universe, the due diligence conducted by FOHF managers provides an added layer of oversight, analysis, and risk monitoring that individual investors would struggle to match.

4. Risk Management – Professional FOHF managers construct portfolios to target specific risk/return objectives and actively manage allocations to adapt to changing market environments. This dynamic risk management enhances the chance of achieving objectives.

5. Liquidity – The FOHF structure provides monthly or quarterly liquidity to investors in the fund shares, while underlying hedge funds often have lock-up periods and less frequent liquidity. This liquidity mismatch risk is managed by the FOHF manager.

6. Lower Volatility – Due to their diversified nature, FOHFs typically exhibit lower volatility than individual hedge fund investments. This helps mitigate volatility drag over time.

7. Operational Ease – It is operationally easier for investors to simply invest in a single well-run FOHF rather than attempt to build their own portfolio of hedge funds which requires extensive due diligence.

While not risk-free, a prudently constructed and managed FOHF can provide investors with an accessible way to invest in hedge funds while benefiting from instant diversification, professional management, risk management, and superior liquidity.

What are the Risks Associated with Investing in a Fund of Hedge Funds?

While offering many advantages, funds of hedge funds also come with risks that investors should be aware of, including:

1. Layered Fees – Being funds of funds, investors pay a management fee and performance fee charged by the FOHF manager in addition to the underlying hedge fund fees. This results in higher total fees compared to direct hedge fund investments.

2. Complexity – The multi-layer structure creates complexity and reduced transparency relative to investing in individual hedge funds directly.

3. Liquidity Mismatches – There is a risk of liquidity mismatches between the FOHF’s redemption terms and the liquidity constraints of the underlying portfolio.

4. Correlations – Diversification benefits are reduced when correlations across strategies rise during periods of market stress, decreasing portfolio benefits.

5. Manager Risk – Issues with an individual underlying hedge fund manager can create losses within the FOHF portfolio that may not be eliminated by diversification during periods of systemic market stress.

6. Leverage – While FOHFs themselves do not utilize leverage, underlying hedge funds within the portfolio often use leverage which introduces risks.

7. High Water Marks – The use of high water marks by underlying hedge funds for performance fee calculations may reduce performance fee expenses during periods of portfolio losses.

8. Transparency – There is limited visibility into the individual hedge funds held by the FOHF, requiring investors to rely on the capabilities of the FOHF manager.

As with any investment, there are trade-offs to consider. Proper due diligence on the FOHF manager and an understanding of the underlying sources of risk and return is required to determine if investing through a fund of hedge funds aligns with an investor’s objectives and risk tolerances.

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What is the Role of a Fund of Hedge Funds Manager?

The FOHF manager plays an integral role in constructing and overseeing the fund of hedge funds portfolio. Key responsibilities include:

Portfolio Construction – Determines the fund’s strategy, sub-strategy allocation targets, risk/return objectives, diversification goals, and position sizing based on underlying hedge fund targets.

Manager Selection – Sources and screens hedge funds, conducts due diligence, evaluates track records, and constructs a portfolio of highest conviction managers.

Due Diligence – Undertakes investment and operational due diligence on underlying hedge funds to assess infrastructure, controls, talent, strategy viability, and risks.

Allocation – Determines target allocations to underlying hedge funds based on the desired portfolio construction weights. Adjusts allocations dynamically over time when necessary.

Risk Management – Ongoing risk management via monitoring of portfolio concentrations, correlations, volatility, liquidity, and counterparty exposures. Rebalances positions based on risk tolerances.

Monitoring – Tracks performance of underlying hedge funds, evaluates any style drift, monitors risk levels, and watches for changes that may warrant reducing or removing a position.

Operations – Responsible for operational aspects like share issuance, subscriptions/redemptions,Strike backtracking, and launch of side pockets if necessary.

Reporting – Provides transparent and comprehensive reporting to investors on portfolio performance, risk metrics, attribution, and other details.

Investor Relations – Engages with existing and prospective investors to address inquiries and educational requests.

Overall, the FOHF manager has a fiduciary duty to act in the best interests of the fund’s investors. Their oversight of the portfolio, manager selection, and risk management are crucial given the complex and opaque nature of the hedge fund universe.

What are the Typical Fees Charged by Funds of Hedge Funds?

Investing through a fund of funds comes with additional fees charged for the FOHF manager’s services in overseeing the portfolio:

Management Fee – An annual management fee of 1% to 2%, charged on assets under management. This covers the FOHF manager’s costs for selecting hedge funds, due diligence, operations, reporting, and overhead.

Performance Fee – An incentive fee of usually 10% to 20% charged on any returns generated above the high water mark. There is typically also a preferred return hurdle rate. This motivates and rewards the manager for generating positive returns.

In addition, investors pay the underlying hedge fund fees, which typically consist of:

• A 1% to 2% management fee
• A 15% to 20% performance fee on investment profits

Total Fees – All-in, investors in a FOHF may pay around 3% in total management fees and 25% of profits in performance fees (with both levels charging fees). The layered fees lead to higher total costs than direct hedge fund investing.

Proper due diligence is necessary to ensure the FOHF’s fees are reasonable relative to their expected value-add and risk exposures. Like hedge funds, FOHF fees incentivize managers to perform well on an absolute return basis on behalf of their clients.

What Hedge Fund Strategies Do Funds of Funds Invest In?

Since funds of funds aim to provide diversification across investment strategies and asset classes, they will typically allocate capital across a wide range of hedge fund approaches. Some common strategies seen in FOHF portfolios include:

Long/Short Equity – Takes long and short stock positions based on fundamental or quantitative research insights. Provides exposure to stock markets with lower net exposure.

Event-Driven – Invests in securities of companies undergoing corporate events like mergers, spin-offs, restructurings and other catalysts.

Relative Value – Attempts to take advantage of pricing discrepancies between related financial instruments like bonds and CDS.

Credit – Invests actively in corporate bonds and credit derivatives to capitalize on credit market opportunities.

Global Macro – Aims to profit from macroeconomic trends and events by trading in global equities, bonds, currencies and commodities.

Managed Futures – Utilizes systematic trend following models on futures and currency forwards across asset classes. Provides uncorrelated returns.

Multi-Strategy – Allocates capital dynamically across multiple hedge fund strategies in order to adapt to evolving market opportunities.

A well-constructed FOHF will combine strategies that exhibit differentiation in their return drivers, risks, and correlations in order to provide investors with truly diversified hedge fund exposure. Portfolio managers may also evolve strategy allocations over time as market conditions and relative value opportunities change.

How to Evaluate a Fund of Hedge Funds Manager

When assessing a prospective fund of hedge funds manager, key due diligence areas include:

Team – Evaluate experience and track record of the key portfolio managers and analysts performing manager selection, due diligence, and portfolio management. Look for specialized expertise.

Strategy – Understand the manager’s investment philosophy, return objectives, risk management approach, strategy allocation methodology, and performance targets.

Processes – Review the processes for hedge fund manager sourcing, due diligence, portfolio construction, risk monitoring, and operations. Assess their comprehensiveness.

Risk Management – Examine how portfolio risks like volatility, correlations, liquidity, leverage, and concentration risk are measured and managed. Determine if the approach aligns with your risk tolerances.

Terms – Assess the compensation structure, liquidity terms, redemption policies, use of gates and hurdles, and any preferential terms for principals versus outside investors.

Transparency – Gauge the degree of transparency into portfolio holdings, exposures, concentration, attrition, liquidity, and drivers of return provided to investors.

Operations – Verify that operations, technology infrastructure, and business continuity plans are institutional quality and follow best practices.

Service Providers – Review the qualifications of third-party vendors providing administration, custody, audit, and legal services to ensure quality operational support.

Conducting thorough due diligence across these areas allows investors to gain assurance that the FOHF manager has the skill set, resources, and institutional-grade infrastructure necessary to effectively construct and manage hedge fund portfolios on their behalf.

Trends in the Fund of Hedge Funds Industry

The FOHF industry has undergone shifts in recent years in terms of assets under management, fees, and portfolio positioning:

• AUM consolidation – Assets have become more concentrated with larger multi-billion dollar FOHFs that can exert greater influence on underlying hedge fund managers.
• Lower fees – FOHF managers have reduced fees in response to criticism of the layered fee structure. Both management and performance fees have declined.
• Direct competition – Some very large institutional investors now directly build hedge fund portfolios themselves rather than utilizing FOHFs.
• Strategy shifts – FOHFs have incrementally reduced exposure to strategies like long/short equity while increasing allocations to credit, relative value, and macro which can generate uncorrelated returns.
• Niche offerings – There is growing interest in niche offerings like Impact Investing FOHFs focused on ESG principles or Small Manager FOHFs providing access to newer managers.
• Improved transparency – In response to investor demands, managers are providing increased transparency into portfolio holdings and exposures.
• Focus on liquidity – Liquidity risk management has become more stringent after experiences during the 2008 financial crisis. FOHFs are being more selective around manager liquidity terms.

Overall, the FOHF industry continues to evolve by aligning itself with shifting investor preferences and market dynamics. FOHFs remain an attractive vehicle for those seeking professional hedge fund portfolio management coupled with diversification.

To Recap

FOHFs offer investors efficient access to portfolios of hedge funds across diverse investment strategies. By conducting due diligence and combining complementary managers, FOHF managers construct institutional-quality portfolios unattainable by most individuals.

Benefits include diversification, professional management, risk monitoring, and improved liquidity terms relative to direct hedge fund investments. However, the layered fee structure results in higher total costs. Performing thorough due diligence is key to selecting top-tier FOHF managers most capable of adding value to investor portfolios.

Carefully built and managed funds of hedge funds continue to serve an important role in providing efficient access to the hedge fund universe for both individual investors and institutions seeking absolute returns. As a portfolio diversifier, they can improve long-term risk-adjusted returns. Overall, funds of funds offer an attractive route to participate in alternative investment strategies.

Frequently Asked Questions

What is a fund of hedge funds?

A fund of hedge funds (FOHF) is an investment vehicle that allocates capital across a diversified portfolio of individual hedge funds. The FOHF provides access to multiple managers and strategies through a single investment.

How is a FOHF structured?

A FOHF pools investor capital into a fund structure which purchases shares in underlying hedge funds based on allocation targets and due diligence. The FOHF manager oversees the portfolio. Investors purchase shares of the FOHF.

What are the major benefits of investing through a FOHF?

The key benefits are diversification across many hedge funds, access to top-tier managers, risk management from the FOHF manager, improved liquidity terms, and professional oversight over complex strategies.

What are the primary risks associated with FOHFs?

Main risks are layered fees increasing costs, complexity reducing transparency, manager risk being concentrated, and liquidity mismatches between the FOHF and underlying hedge funds.

Do FOHFs provide better returns than investing directly into hedge funds?

FOHFs do not necessarily provide higher returns. Through diversification, they aim to provide competitive long-term returns with lower volatility and reduced downside risk compared to individual hedge fund investments.

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