Buying a mutual fund is a bit like hiring someone to fix the brakes on your car. Sure, you could do the research, buy the tools and fix the car yourself (and many people do), but often it's not only easier but also safer to let an expert handle the problem. Mechanics and mutual funds may cost you a little more in fees, but there is nothing inherently wrong with paying extra for peace of mind. Mutual funds usually allow investors to skip the murky, confusing world of stock picking, but what if stocks aren't the asset class you're interested in? With their million-dollar buy-ins and dangerous reputations, hedge funds were once the exclusive investment vehicles of the rich and powerful, but now regular investors have a way to get in on the action through a fund of funds.

A fund of funds (FOF) is an investment product made up of various hedge funds - basically, a mutual fund for hedge funds. They are often used by investors who have smaller investable assets, limited ability to diversify within the hedge fund arena, or who are not that experienced with this asset class. In this article we will explore the advantages, disadvantages and risks of an FOF.

Fund of Funds Vs. Hedge Funds
Individual hedge funds often focus on a particular strategy or market segment, tying their returns to those areas. FOFs, on the other hand, pool investor money and buy individual hedge funds for their portfolio, thereby holding a number of funds with different strategies. FOFs provide instant diversification for an investor's hedge fund allocation and the opportunity to reduce the risk of investing with a single fund manager.

Most hedge funds are sold through private placements, which means they have restrictions imposed on them under Regulation D of the Securities Act. An important restriction is the limit on investors who are permitted to invest in the fund. Most hedge fund investors must meet accredited investor requirements, meaning that individuals must have a net worth of $1 million excluding one's primary residence or total income exceeding $200,000.

The convergence between the hedge fund and mutual fund industries is being pushed by demand from investors to beat the market. Hedge funds traditionally catered to the rich, but with that niche now served by thousands of funds, new investors are being sought and hedge funds are going down-market, reducing their investment minimums and seeking creative ways to allow those who are less well off to access these investment products. One way to get around the traditional limits on unaccredited investors is to register a hedge fund with the Securities and Exchange Commission (SEC). Registered FOFs can have lower minimum investments than private hedge funds and can be offered to an unlimited number of investors. However, unlike registered mutual funds, there is no secondary market available, so you won't be able to sell your investment readily.

Fees and Expenses
Hedge funds typically charge asset-based fixed fees that range between 1-2%, but these fees can go all the way up to 3% or even 4% annually. Incentive or performance fees may also be part of the compensation package and can sometimes be between 10-40% of any capital gains. Performance fees are often structured so that they have a "high-water mark," which ensures that the manager does not receive this compensation until previous losses by the fund are made up.

An investor who purchases an FOF must pay two levels of fees. In addition to management fees and a performance fee, which are charged at the individual hedge fund level, additional fees are charged at the FOF level as well. Just like an individual fund, an FOF may charge a management fee of 1% or more along with a performance fee, although the performance fees are typically lower to reflect the fact that most of the management is delegated to the sub-funds themselves.

FOF Advantages
Hedge funds make up their own asset class, which can be opaque at times. Thousands of hedge fund managers are making it difficult to weed out the good from the mediocre. An FOF serves as an investor's proxy, performing professional due diligence, manager selection and oversight over the hedge funds in its portfolio. The professional management provided by an FOF can give investors the ability to dip their toes into hedge fund investing before they tackle the challenge of individual fund investing.

Most FOFs have a formal due-diligence process and will conduct background checks before selecting new managers. In addition to searching for a disciplinary history within the securities industry, this work can include researching the backgrounds, verifying the credentials and checking the references provided by a hedge fund manager who wishes to be chosen for the FOF.

Hedge funds typically have high minimum investment levels, which restricts the ability of many investors to diversify their portfolios within the allocated amount for hedge funds. With an FOF, investors with limited capital can access a number of fund returns with one investment, achieving instant diversification. The fund selection process can provide greater stability (i.e., lower volatility) of returns by spreading assets over a broader range of strategies. Rather than assuming the risk of selecting one individual manager, the FOF provides a portfolio of managers with a single investment.

FOF Disadvantages
Overall, fees for FOFs are typically higher than those of traditional hedge funds because they include both the management fees charged by the FOF and those of the underlying funds. This doubling up of fees can be a significant drag on the overall return an investor receives.

Hedge funds are similar to mutual funds in that they pool investor money and invest the assets of the fund in a variety of investments. But unlike mutual funds, hedge funds are not required to register with the SEC and are typically sold in private offerings. This means that positions within hedge funds don't have to be publicly reported the way mutual fund holdings must be. However, hedge funds are still subject to the basic fiduciary responsibilities as registered investment advisors.

The SEC and other securities regulators generally have a limited ability to perform routine checks on hedge fund activities. This reduces the likelihood that these agencies will ferret out any wrongdoing early on. And since an FOF buys many hedge funds (which themselves invest in a number of securities), the FOF may end up owning the same stock or other security through several different funds, thus reducing the potential diversification.

Risks
Hedge fund investing is more complicated and involves higher risk than many traditional investments.

Gates and Locks-Ups
Some hedge funds have lock-up periods during which investors must commit their money; these can last several years. Hedge funds typically limit opportunities to redeem, or cash in, shares, such as only quarterly or annually. This reduces an investor's ability to take cash out of a fund in times of market turbulence. Gates, or limits on the percentage of capital that can be withdrawn on a redemption date, also restrict the ability of hedge fund investors to exit a fund. This feature is increasingly common. Hedge fund managers need gates to reduce variability in portfolio assets, and anything that protects against a mass exodus of capital helps this goal. Gates are most likely to be used when markets sour, which is exactly when an investor may want to redeem shares.

Manager Risks
An FOF depends on the expertise and ability of the fund's manager to select hedge funds that will perform well. If the FOF does not achieve this goal, its returns are likely to suffer.

Performance fees can motivate hedge fund managers to take greater risks in the hope of generating a larger return for themselves and their investors. If a manager gets a large cut of the capital gains of a fund, he may take undue risks to profit from the potential returns. If a hedge fund manager is an active trader, the frequent transactions can result in higher tax consequences than a buy-and-hold strategy. Higher taxes will reduce the overall return an investor receives on his or her investment, all else being equal.

Most hedge funds use leverage and short selling to some extent to generate returns or hedge against falling markets. Both of these strategies increase the investor's risks. Short positions can lose an unlimited amount of money, while leverage can magnify losses and make quick movements in and out of the markets much more difficult.

The Bottom Line
FOFs can be a pain-free entrance into the harsh hedge fund world for investors with limited funds, or for those who have limited experience with hedge funds, but this doesn't mean every FOF will be the perfect fit. An investor should read the fund's marketing and related materials prior to investing so that the level of risk involved in the fund's investment strategies is understood. The risks taken should be commensurate with your personal investing goals, time horizons and risk tolerance. As is true with any investment, the higher the potential returns, the higher the risks.

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