Hedge Funds: Funds Of Funds

By Dan Barufaldi

Funds of hedge funds are an alternative to investing directly into individual funds. There are advantages and disadvantages to funds of funds, and the benefits to an investor are completely dependent on the investor. Funds of funds are well diversified investment vehicles made up of a variety of other funds. They typically have lower minimums and are a good way to invest in hedge funds with broad diversification. Some funds of funds invest in hedge funds with a variety of different strategies and a much higher level of diversification, while others, called single-strategy funds, will invest in a variety of funds having the same or similar strategies.

Benefits
One of the benefits of fund of funds is that they enable an investor to obtain instant diversification in a portfolio of hedge funds, which is particularly attractive for an investor with a portfolio that is large enough to invest in hedge funds, but too small to achieve proper diversification going directly into hedge funds. For example, with hedge fund minimums often starting at $1 million, it would be difficult for an investor with a $2 million account to diversify their portfolio of hedge funds. The maximum number of hedge funds they could invest in is two, and that would not be a very prudent diversification strategy. A fund of funds, however, that is invested in 15-20 hedge funds and has a minimum investment of $500,000 enables the investor to gain exposure to the alternative asset class without compromising the overall structure of the portfolio.

As mentioned, some funds of funds are single-strategy funds, while others make investments in funds using a variety of different strategies. The multi-strategy funds provide broader diversification and uncorrelated returns within underlying funds. The investor in this case relies on the skill of the fund manager to allocate the portfolio to appropriate strategies and to monitor and tactically adjust the portfolio as needed. An investment in a quality multi-strategy fund of funds is also appropriate for investors who do not have the skill or resources to determine which strategies are attractive in the current environment.

The single-strategy fund of funds, on the other hand, would require an investor decision to add exposure to a particular type of strategy. I would hope that this type of investor has the resources to evaluate such a decision and make an allocation to this fund after careful evaluation of the overall portfolio.

Conclusion
It is important to assure that the fund of funds has well diversified funds even though they may use the same strategy. For example, if evaluating a long/short fund made up of 15-20 funds, it would be prudent to understand the sub-categories of each of the funds, such as whether they are sector-specific, domestic or global, value or growth-oriented, the level of gross and net exposure inherent in their strategy, and others. Most funds of funds will do a good job of diversifying across a variety of sub-strategies, but an investor should make sure this is the case. (You can learn more about these investments at Fund Of Funds – High Society For The Little Guy and Hedge Funds Go Retail.)