Strategies
Look
Through Vehicles: Fund of Funds
Simply
put, a fund of funds is a one that invests in other hedge funds.
By it's very nature it does not make direct investments, and it
is therefore known as a "look through" vehicle. Ordinarily, a fund
of funds is set up (structured) as a limited partnership which can
afford the investor in a fund of funds certain advantages. One such
advantage is due diligence. The fund of funds manager spends considerable
time evaluating, identifying strategies and selecting the hedge
funds to implement them. Depending on the expertise of the fund
of funds manager, this can yield superior investment results. Moreover,
the fund of funds can control risk by achieving manager diversity.
They accomplish this by diversifying in the strategies those managers
employ. To the investor, this allows them to participate in a unique
asset allocation mechanism while hopefully limiting downside risk.
Fund
of funds are not without disadvantages, however, and we would be
remiss not to discuss them. The most notable of these is that an
investor in a fund of funds is required to pay an additional layer
of fees. Usually, these fees range from 1 to 2 percent of assets,
but some fund of funds charge a performance fee, too. However, the
SEC limits the number of fees an investor can pay. Furthermore,
it is wise to remember that a fund of funds is only as good as it's
manager and the underlying funds it invests in.
Technically,
any fund that acts as a pool of capital and uses two or more submanagers
to invest that capital whether it is debt, equity, commodities,
derivatives, or currencies, is a fund of funds. Any combination
of the above instruments may be used depending on the objectives
of the fund. Because of the looseness of the definition, a pension
fund or an endowment fund can be considered a fund of funds. But
for clarity, the discussion here is limited to a fund of funds in
and how they relate to hedge funds.
Some
diagrams that help visualize the fund of funds and its relation
to the underlying layer of hedge funds:
Figure
1 -- Fund of Funds with Combined Strategies.
This
theoretical example illustrates how the fund of funds manager is
able to create a fund with a balanced risk posture. Many fund of
funds utilize a multi - strategy approach with many managers.
Note:
Under each listed strategy the number of hedge fund managers implementing
each one is in brackets.
Figure
2 -- A theoretical Fund of Funds following a Dedicated Strategy
approach.
In
this theoretical example, the Fund of Funds manager is investing
in a "dedicated strategy" approach which involves placing money
with various hedge fund managers who, in turn, invest in various
sectors of the U.S. equities market. Manager #1 is investing in
growth stocks while the other managers are involved with specific
sectors of the stock market, i. e., financial stocks, or technology,
etc.