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.
