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 there is a way for regular investors 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
a fund of funds.
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 upon 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 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 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.
For an investor who purchases an FOF, there are two levels of fees that must be paid. In
addition to management fees, which are charged at the individual hedge fund level, there are
additional fees 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. There are
thousands of hedge fund managers 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
fund of funds.
Hedge funds typically have high minimum investment levels, which restricts the ability of
many investors from diversifying their portfolios within the allocated amount for hedge
funds. With an FOF, those 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 funds of funds 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 fund of funds 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 in order 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 in order to generate returns
or hedge against falling markets. Both of these strategies increase the risks for an investor.
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.
Final Thoughts
FOFs can be pain-free entrance into the harsh hedge fund world for investors with limited
funds, or for thos 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.
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 there is a way for regular investors 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
a fund of funds.
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 upon 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 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 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.
For an investor who purchases an FOF, there are two levels of fees that must be paid. In
addition to management fees, which are charged at the individual hedge fund level, there are
additional fees 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. There are
thousands of hedge fund managers 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
fund of funds.
Hedge funds typically have high minimum investment levels, which restricts the ability of
many investors from diversifying their portfolios within the allocated amount for hedge
funds. With an FOF, those 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 funds of funds 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 fund of funds 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 in order 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 in order to generate returns
or hedge against falling markets. Both of these strategies increase the risks for an investor.
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.
Final Thoughts
FOFs can be pain-free entrance into the harsh hedge fund world for investors with limited
funds, or for thos 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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