One hedge fund strategy is a hedge fund of funds or fund of funds for short. Fund of funds managers invest in other hedge funds rather than trade directly in the financial markets, and thus offer investors broader exposure to different hedge fund managers and strategies. Like hedge funds, funds of funds may be exempt from various aspects of federal securities and investment law and regulation.

Structure and Offering documents

As noted above the FOF structure is generally the same as a regular hedge fund. The FOF manager will need to consider whether he will need to be registered as an investment advisr with the SEC or state securities commission. The FOF also may be a 3(c)(1) fund or a 3(c)(7) fund and of course, the FOF may also be an offshore fund. The fund of funds offering documents are going to look exactly the same as the hedge fund.

Fund of Funds Fees

FOFs regularly face a lot of criticism for the fee structure. FOFs will generally charge annual management fees of 0.5% to 1.5% and annual performance fees of 5% to 15%. These fees are on top of the management and performance fees which are paid out at the fund level. Because of the two layers of fees FOFs can be very expensive.

Reason for FOFs – Diversification

Although FOFs face criticism because of their high fees, they do offer investors a greater degree of diversification than individual hedge funds. Because FOFs invest in many hedge funds the performance of any single hedge fund will not, in theory, affect the whole portfolio. In extremely volatile times like we are currently experiencing, the FOF is trying to dampen volatility by being diversified. Many FOFs can weather these volatile times, but many FOFs are suffering along with their underlying funds.

Reason for FOFs – Access to managers

One of the main selling points to accredited and high net worth investors is access to hedge funds and managers which the individual investor may not have access to. Many of the very large premier hedge funds are no longer open to any investors. These premier hedge funds may, every so often, open their funds for new investments by existing investors. FOFs which have an investment with these managers will be able to get investor money into these funds.

Many individual hedge funds have very high minimum investment requirements which certain individual investors would not be able to meet. An accredited investor with $250,000 to invest will not be able to invest in a fund with a $1 million minimum, but that same investor will be able to get exposure to that fund through a FOFs. By pooling money from many investors the FOF is able to meet the minimums to these hedge funds with high minimum investments.

Reasons for FOFs – Due Diligence

Fund of fund managers are expected to perform in depth due diligence on the underlying hedge fund investments. This includes both operational due diligence as well hedge fund manager background checks. Many times a FOF manager will actually make in-person visits to the hedge fund’s offices to make sure that the hedge fund is not acting fraudulently.

Entry point for Institutional Investors

Fund of funds serve as a common entry point for institutional investors who want to get into the alternative investment arena. While there is a very large amount of assets in hedge funds through institutional investors, investments by these groups is growing at a great rate. Because these investors are typically conservative by nature, the more diverse FOFs serve as a great way for the investor to test the alternatives market. It is expected that institutional investors will become even bigger players in the alternatives area and therefore it is expected that FOFs will continue to serve as a good entry point to the industry.

For more information on this topic, please see our earlier post (GAO hedge fund report) which details what institutional investors look for when they invest in hedge fund of funds.

Non-active management – Sponsor

The FOF managers main job is to monitor investments in underlying hedge funds. While most fund of hedge funds managers were once active stock pickers, brokers or other industry professional, we are seeing the advent of the FOF manager who is really a sponsor of the fund of funds. A great example of this is Ron Insana, the CNBC analyst who became a FOF manager.

These types of FOF managers have great connections and are able to raise assets for investments in hedge funds but will not spend as much time determining the investments which will be made in the fund. In fact these managers may hire a sub advisor (paid out of the management fee) who will determine the investments the FOF will make. Other parts of the FOF back office can be outsourced – for instance there are firms which will do much of the initial hedge fund manager screening (through databases and other sources) and hedge fund due diligence. If you would like more information on these groups, please contact us.