What is a "Fund of funds?"
A fund of funds is a hedge fund that invests money in several other hedge funds.
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There are two main categories of fund of funds:
- Diversified, in which assets are invested in various types of hedge funds.
- Niche, in which assets are all invested in funds of a similar type/strategy.
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There are several advantages to investing in a fund of funds:
- Instant diversification: investor can spread money between many different
strategies/managers.
- Lower minimum investment, sometimes as low as $250,000.
- Avoids problem of finding 5 or 6 different hedge funds to invest in, in an
environment that does not allow hedge funds to advertise.
- Because of an existing relationship between the fund of funds and an
underlying fund, there may be access to funds that are otherwise closed.
- Because funds of funds are volume buyers, participation in a desirable fund
may be gained at a lower price.
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Caveats for Investing in a Fund of Funds:
- Liquidity: Fund of funds cannot offer greater liquidity than its components.
- Fee Structure: Funds of funds charge another 1 to 3% fee on top of the fees
charged by the underlying funds.
- Since the underlying make-up of funds of funds varies so greatly, it is very
difficult to compare performance from one fund of fund to another.
- Similar lack of transparency as a singular hedge fund.
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How are funds of funds formed?
Investment advisers often become fund of fund managers-they do all the initial
research for clients and find they can make more money if they create their own
fund of funds than by having clients invest in all the different funds. The same
process as starting a domestic U.S.A.-based fund is generally required for starting a fund of funds.
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What criteria should I use to evaluate potential fund of funds managers?
The following is a list of questions that will help a potential investor establish some criteria for evaluating managers:
- What is the size of the fund? In other words, what is the buying clout of the fund?
- What is orientation?
- What is manager's methodology for selecting strategies and funds?
- What depth of due diligence does the manager perform on each fund?
- What ongoing monitoring processes are maintained?
- When are funds pruned from FOF?
- Does the fund credit rebates to the limited partners or the general partner?
- How much of manager's own capital is in fund?
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