A Fund of Hedge Funds (FOHFs), referred by Mitra (2009), is a Mutual Fund that invests in multiple Hedge Funds (e.g., 15-25 diﬀerent Hedge Funds) and provides diversiﬁcation beneﬁts and a method of investing in Hedge Funds without requiring the investor to assess Hedge Funds individually. FOHFs provide a diversification effect that comes from minimizing the idiosyncratic risks inherent to investing in individual managers.
FOHFs have significantly lower minimum investment levels compared to a standard Hedge Fund, increasing investment access to the general public.
Also, simulations show that a higher number of funds reduce volatility and drawdowns leading to an improved preservation of capital; an FOHF allows an allocation to a range of a multi-strategy portfolio in one single vehicle or several managers competent in a given strategy serving a particular purpose in an investor’s asset mix.
Investors benefit from partnering with an FOHF that has been constructing and selecting hedge fund portfolios, over different economic cycles, for a variety of the various clients.
This resource allows FOHFs to optimize terms regarding reporting, liquidity, operational workflows and transparency.
Risk management experience and other intangibles
When investing in hedge funds the ability to identify and understand risk characteristics is one of the most important issues where a fund of funds manager will have to demonstrate the experience as well the skill in the field of the most sophisticated trading strategies.
This will allow the fund of funds manager to assess potential drawdowns for each manager in each strategy irrespective of his historical track record, getting a feel for the risk of the overall fund when 25%, 50% or even 75% of managers experience a drawdown at the same time.
Agreeing with the AIMA’s Roadmap to Hedge Funds (2008), a well-established hedge fund investor or a fund of funds manager can have a wider allocation window than other investors due to a combination of investor relationships and pedigree.
Finally, an investor evaluating a fund of funds manager will want to assess whether the manager is equipped to manage the laborious task of due diligence on an increasing number of funds given the importance of qualitative research and due diligence.
Ineichen, A., 2008, “AIMA’s Roadmap to Hedge Funds”, The Alternative Investment Management Association (AIMA), UBS Global Asset Management;
Mitra, S. 2009, “An Introduction to Hedge Funds”, arXiv.org, Quantitative Finance Papers