Funds of Hedge Funds Defined

funds of hedge funds

So far, we have discussed the various strategies that Hedge Funds use to earn profits and operate in a financial market. The main purpose behind the existence of Hedge Funds is to seek investments from other investors and then make use of the funds by buying and selling complicated instruments and financial tools.

What are Funds of Hedge Funds?

Funds of hedge funds are an alternative investing strategy that allows investors to invest into different individual funds. Funds of hedge funds are highly diversified investment portfolios that comprise of several other funds.

Among the many players on the trading floor, Hedge Funds are considered one of the most risk-loving competitors. They are institutional investors who have a large asset base to back their risky investments and make sure they yield profits. The most common investments that make up the portfolio of a Hedge Fund are those individual instruments in which the company invests directly.

Apart from these, many Hedge Funds also implement a practice called Funds of Funds, a strategy in which it invests in the shares of various other Hedge Funds operating in the market. This means that apart from the individual stocks and bonds trading on the market, the manager of a particular Hedge Fund also manage an alternative instrument- the portfolio of which is made up of shares of other investing institutions.

Funds of Hedge Funds Strategy 

Such institutions do not need to be Hedge Funds only; in fact, they can be private equity funds, mutual funds and other insurance companies. Funds of Hedge Funds is a very popular strategy that is usually a must for a well-balanced portfolio. Just as a thought process is involved in choosing which stocks to purchase, the decision regarding which investment funds to include in the portfolio of a Hedge Fund is made after a lot of deliberation.

Qualitative and quantitative analysis is done to make sure that the fund being included is stable, has the adequate tools and knowledge required to make calculated decisions and has a history of stable performance. Therefore, different approaches and strategies are used to access new investment funds that are made part of the Funds of a Hedge Fund.

Why ‘Funds of Funds’ strategy might be good?

There are many benefits and limitations of using the Funds of Hedge Funds strategy. The biggest benefit that a Hedge Fund gets is instant diversification of risk and exposure. Since this strategy belongs to the alternative class of investment, it gives the trader a great chance to spread risk across the portfolio more evenly.

A Funds of Funds strategy also lets average size investors make use of this diversification. For instance, an investor whose net worth is $2 million cannot invest in Hedge Funds if the minimum required initial investment is $1 million for it. Following this rule, the investor can only make two Hedge Fund investments, which is a very risky endeavor. Having all eggs in one basket can be very worrisome for even the most experienced traders owing to the uncertainty of the financial market.

However, with a Funds of Funds strategy, this minimum amount is lowered to $500,000, giving the investor a fair chance to put money in the Funds of Hedge Funds instead of investing it all in directly purchased stocks and bonds. By doing so, an average investor’s portfolio can have a stake in some of the country’s best Hedge Funds and that too at a very reasonable price!

Perhaps the one disadvantage that surrounds Funds of Hedge Funds is the incremental fee structure followed. While this strategy makes Hedge Fund investments more accessible, it also adds a number of other fees that must be paid if you want your investment to be counted. Some of the most prominent fees charged by Funds of Funds include the following:

  • 2% for Assets under Management.
  • 20% Incentive Fee from profits generated.
  • A percentage charged by the Funds of Funds as its own fee.

When combined, the total fees can add up to a number far greater than the cost of investing in individual assets.

Are Funds of Funds a Right Choice for the Investor?

Apart from the cost factor, Funds of Hedge Funds is a good strategy to make use of. According to experienced professionals, the cost of investing in Funds of Funds is more than made up for with the above average returns that this strategy earns for the investor.

The funds-of- hedge funds industry is becoming increasingly popular among the hedge fund investors and managers. The reason behind this popularity is the substantial returns brought by the funds-of- hedge funds. According to research report, funds-of- hedge funds have gained 35 percent new inflows in 2000 as compared to the 11 percent inflows that were received in the1990s. 

Therefore, it is unanimously agreed that the Funds of funds is a tried and trusted way to diversify a portfolio, provided that the Hedge Fund has been run for a background check by analysts first.

Future of Funds of Hedge Funds

Funds of hedge funds have brought tremendous consolidation and outflows, but yet they are still considered as the effective strategy. Gil Ottensoser, head of capital of the Deutsche Bank commented on the future of funds of hedge funds saying that “fund-of-funds outflows have stabilized, in part because firms have changed their business models to keep up with the times.

In the future, hedge fund managers should look for fund-of-hedge funds managers who offer customizes services, fair fee, depict excellent skills to diversify the portfolios for greater returns.