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Hedge Fund of Funds Investing: An Investor's Guide

Hedge Fund of Funds Investing: An Investor's Guide

4.5 2
by Joseph G. Nicholas, Nicholas

Hedge funds have rightly gained the attention of private and institutional investors in recent years, proving themselves as useful portfolio diversifiers and preservers of wealth while greatly dispelling their reputation as an "unsafe" investment. Yet investors attempting to navigate in the field of hedge funds face significant challenges: the large number of


Hedge funds have rightly gained the attention of private and institutional investors in recent years, proving themselves as useful portfolio diversifiers and preservers of wealth while greatly dispelling their reputation as an "unsafe" investment. Yet investors attempting to navigate in the field of hedge funds face significant challenges: the large number of funds, the diversity of strategies used, the range of financial instruments traded, and the various formats for investing.

Pooling multiple hedge funds together into one vehicle, the fund of funds provides a ready solution, combining professional management expertise with asset allocation. In this book—the first of its kind—industry expert Joseph Nicholas shows investors how these funds operate, the benefits and risks, and the criteria and due diligence to utilize when selecting funds. Nicholas provides an in-depth analysis of historical fund performance and offers unique insight into the industry and trends that may affect its evolution.

Clear, insightful, and illustrated with numerous charts and graphs, Hedge Fund of Funds Investing is an essential resource for serious investors.

Product Details

Publication date:
Bloomberg Financial Series, #9
Edition description:
Product dimensions:
6.00(w) x 9.00(h) x 0.81(d)

Read an Excerpt

Hedge Fund Of Funds Investing

An Investor's Guide
By Joseph G. Nicholas

Bloomberg Press

Copyright © 2004 Joseph G. Nicholas
All right reserved.

ISBN: 1-57660-124-2

Chapter One

Fund of Funds in the Hedge Fund Industry

Hedge Fund Investment Options 4 Direct Investment 5 Customized Portfolio 5 Index Fund 6 Fund of Funds Investment 6 Growth of Funds of Funds 6 Hedge Fund Industry Characteristics and Trends 11 Hedge Fund Investment Structure 14 Legal Structure 16 Numbers of Investors and Minimum Investment Size 17 Reporting and Disclosure 19 Liquidity 19 Lockup 21 Summary 21

A fund of funds (FOF) is a fund whose investment strategy is to allocate capital to two or more hedge funds. Investors purchase an interest in a fund of funds, and their assets are commingled with those of other investors. This pool of money is invested with a number of hedge funds. The basic structure is diagramed in Figure 1-1.

It is estimated that there are more than nine hundred funds of funds in operation today, and there are many more being developed. As a group, they represent more than one-third of assets invested in hedge funds.

For most investors, the fund of funds provide an efficient and cost-effective way to invest. It spares them the task of having to select and gain access to suitable hedge fund managers from the ever-expanding universe of investmentpossibilities. It also improves their chance of investing in hedge funds successfully, which requires, as with most successful investments, considerable resources, experience, and time. For investors with smaller assets to invest, a fund of funds provides access to a diversified group of hedge funds that could not be achieved directly due to minimum investment requirements. The private nature of the hedge fund industry-in most cases there is no requirement for hedge funds to publicly disclose information-creates a situation in which experienced firms focusing resources on this investment area can build a significant and sustainable informational advantage that allows them to add value for their investors.

Hedge Fund Investment Options

The decision to allocate capital to hedge funds is based on an evaluation of the merits of the investment opportunities presented by the underlying strategies (for detailed summaries of the strategies and performance achieved, see Chapter 2). Over the past ten years hedge fund strategies have produced compelling risk-adjusted returns on an absolute basis as well as positive diversification benefits when combined with a portfolio of traditional assets. However, the decision to make an investment in hedge funds is only the first step in a multitiered process. Investors must then determine the most appropriate vehicle for accessing hedge fund strategies. This second point presents a hedge fund investor with a number of potential difficulties: with which strategies and which managers should they invest, how much capital should be dedicated, how is the structural risk associated with hedge fund investments controlled, and how will the investments be monitored?

A number of investment options are available. The four principle options are: (1) investing directly in a single hedge fund, (2) building a customized portfolio that combines a number of hedge funds, (3) investing through an index fund, and (4) investing in a fund of funds.

Direct Investment

One approach is for investors to make direct investments into hedge funds they select. Investment minimums for hedge funds, that is, the minimum amount required to invest with a manager, typically range from half a million to several million dollars. Investing directly, therefore, requires significant assets if an investor wants good diversification by manager and strategy. Investing in one or a handful of managers increases the burden of manager selection and increases the risk of substandard performance results because of the concentration of investment.

Customized Portfolio

A second method of direct investment is to create a customized portfolio of hedge funds managed specifically to meet the needs of the investor. The portfolio follows a fund of funds investment strategy, but does not accept outside capital; it is managed internally, either by the investor or in conjunction with an outside investment adviser or consultant. This approach requires the same investment expertise as managing a fund of funds. Because of the cost of hiring experienced investment professionals, plus the expense of legal, accounting, and administration, this is a solution best suited for a large-scale investor who has the resources and commitment to maintain the ongoing analyses and due diligence necessary to prudently manage a fund of funds.

Index Fund

A third way to invest in hedge funds is to access the hedge fund industry or specific strategy returns by investing through an investable hedge fund index. Investing in an index is more cost effective than other approaches and is available to both individual and institutional investors. The goal of the index is to deliver the market return of the hedge fund industry or that of one of its underlying strategies. Unlike a fund of funds, such an index is not actively managed but follows an allocation methodology designed to mimic the collective exposures of the greater hedge fund industry.

Fund of Funds Investment

The fourth approach is to invest in an existing fund of funds. Funds of funds can provide an efficient solution to the challenge of investing in hedge funds. Indeed, they have become the most common means of access for investors who are looking for diversified exposure to hedge funds, but who do not have the resources to research, monitor, and manage multiple hedge funds. For many investors desiring access to hedge fund returns, investing in a fund of funds is an obvious choice. It should come as no surprise, then, that the absolute number and total assets flowing into fund of funds vehicles have contributed greatly to the rapid growth of the hedge fund industry.

Growth of Funds of Funds

The equity culture that reached its apex during the bull market of the late 1990s has been reevaluated, given the sharp losses suffered by investors since the early years of the new millennium. World markets have worked through the excesses of that technology-led bubble. The ensuing recession in the United States, and the realization that equity market returns can remain subdued for an extended period of time, have resulted in investors looking elsewhere for attractive returns that are not dependent on the direction of the equity markets.

Hedge funds possess both of these qualities and, as one might expect, have received substantial asset flows as a result. The number of funds of funds and the assets controlled by these investment vehicles have grown apace. The annual growth rate for fund of funds assets since 1990 has been 48 percent. This compares to an average annual asset growth rate for the hedge fund industry as a whole of 26 percent. The graphs in Figures 1-2 and 1-3 show that fund of funds growth has actually outpaced hedge fund industry growth. While the industry as a whole is quite young, the fund of funds industry is younger still. In fact, as shown in Figure 1-4, more than 75 percent of funds of funds in existence today were started since 1996, and less than 10 percent were in existence in 1990.

Outlined below are the seven most important factors contributing to the rapid growth in both the number of funds of funds and assets in funds of funds.

1 Viability of hedge fund strategies/acceptance of hedge funds. Attracted by the performance-based compensation (which averages about 1.5 percent of assets and 20 percent of profits annually), innovative and flexible strategies, and increasing investor demand, many of the best and brightest minds in the asset management industry have started hedge funds in the past five years. Rapid acceptance of and investment in hedge funds, however, has also drawn in managers who are less seasoned and less experienced in hedge fund strategies and techniques. This proliferation of funds has made the challenging task of selecting appropriate managers even more onerous. As previously noted and discussed in detail later, the fund of funds allows an investor to outsource the responsibility of manager selection and strategy allocation to a team of experienced professionals dedicated full time to the project.

2 Informational advantage. The private nature of the hedge fund industry means that information is not equally distributed among all participants. Funds of funds, however, seek to gain an edge by creating databases of fund information and collating data gleaned from various channels, such as data providers, prime brokers, and industry contacts. Some of this information is available to the fund of funds only because of its position as an asset allocator. The ability of funds of funds to access, collect, and interpret data essential to successful hedge fund investing has been and will continue to be a key driver of their growth.

3 Special access to closed funds. Successful hedge funds may close to new investment in order to preserve their ability to implement their investment strategy. However, funds of funds, as existing investors, often enter into arrangements with favored managers to reserve a certain amount of capacity in the event that the manager's fund becomes closed to new investment. In this way, fund of funds investors may have access to successful funds closed to new investment. Even if no additional capacity remains, a fund of funds investor still participates in the existing exposure in the closed manager.

4 Economies of scale. By pooling investor capital, funds of funds achieve economies of scale. Investing in hedge funds requires high minimums, and the work necessary to perform due diligence and select managers, conduct risk management, and administer multiple investments is costly. Funds of funds help individual investors circumvent problems associated with minimum investment sizes, and share the costs associated with the research-intensive manager selection process, reporting, and aggregating information from multiple hedge fund sources. Therefore, the pooling of capital allows smaller investors a superior and more efficient way to invest in multiple hedge funds.

5 Educational role. As part of its sales efforts, a fund of funds educates investors about the risks and merits of hedge fund strategies and how different performance objectives can be achieved depending on how strategies and managers are combined and managed in a fund of funds portfolio. Many first-time hedge fund investors look to funds of funds not simply as an investment vehicle, but as a way of learning about hedge fund strategies and hedge fund managers along with how they should be selected for incorporation into multiple manager allocations.

6 Diversification. For investors looking to make a representative investment in hedge funds, diversified funds of funds are an obvious choice. By adding more managers, the risk that is specific to any particular manager is reduced. Additionally, some funds of funds seek to achieve defined diversification goals across strategies and substrategies to avoid the risks of having managers taking similar market risk.

7 Performance. Even with all the other factors, funds of funds would not grow without generating good performance. Investors, in general, look to funds of funds to produce attractive absolute returns relative to other investment options and to produce returns above that of the hedge fund industry.

Hedge Fund Industry Characteristics and Trends

Before examining the fund of funds approach to investing in hedge funds, it is essential to first understand the hedge fund industry and the fund of funds' place in that industry.

There are two key aspects of the hedge fund industry to observe:

1 The hedge fund industry consists of a number of different investment strategies. 2 The investment strategies are dynamic, and the percentage of industry investment allocated to each strategy has changed significantly over the past decade.

To understand hedge funds is to understand the variety of investment approaches used by hedge fund managers. Each strategy consists of a number of substrategies or variations on the core investment theme. In Chapter 2, we examine the underlying hedge fund strategies in greater detail. For now, it is important to note that the number, type, and asset size of the strategies and substrategies shift over time, influenced by changes in market conditions, increasing or decreasing opportunities and inefficiencies, and changes in investor demand for return characteristics. The strategies that make up the industry today are not the same as in the past and are likely to be different in the future.

During the 1990s, rapid gains in technology leveled the financial playing field and allowed investment managers to leave their employment at large investment houses and start their own firms. In addition, the bull market gave these managers a great financial incentive to do so. Large asset flows into equities particularly supported the growth in equity-oriented hedge funds. Consider the graphs in Figures 1-5 and 1-6, which show the composition of hedge fund strategies in 1990 and 2002, respectively. During this period, the strategy weights of the hedge fund industry shifted quite dramatically. For example, as increased information flow and efficiency in global markets reduced traditional opportunities for macro investing, the stock market expansion of the 1990s created a broader base for equity opportunities. Note the reduction of industry assets in the so-called Macro strategy allocating from 71 percent in 1990 to 13 percent in 2002, and the corresponding growth in Equity Hedge from 5 percent in 1990 to 30 percent in 2002. (See Figure 1-7.)


Excerpted from Hedge Fund Of Funds Investing by Joseph G. Nicholas Copyright © 2004 by Joseph G. Nicholas . Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

What People are saying about this

From the Publisher
"While hedge fund of funds have proliferated as a relatively new investment vehicle, reliable information about these vehicles has been limited. Joe Nicholas's timely book does a magnificent job of providing concise, valuable information about these popular new funds."
- Dan Rauchle
President, Wells Fargo Alternative Asset Management

"A creative and disciplined work that offers powerful insights into the fast-growing world of fund of funds investing and strategies. A quick and informative read for both the HNW and institutional investor."
- Lawrence Simon
President and CEO, Ivy Asset Management Corporation

"Hedge Fund of Funds Investing provides a thorough, well-articulated discussion of the key characteristics and issues associated with investing in a fund of hedge funds. I believe the frank disclosure of both the advantages and disadvantages of these vehicles, as well as the information on selecting a fund of funds, will make this book required reading for individual and institutional investors alike."
- Frank Belvedere, CFA, FCIA
Vice President of Alternative Investments, Montrusco Bolton, Montreal, Canada

This is a great reference for those who are just beginning to invest in hedge funds, as well as those who already have a hedge fund of funds allocation. If you are new to this investment vehicle, the book provides a thorough description of fund of funds and a great framework for conducting the due diligence process. If you are already invested in fund-of-funds, it will prompt you to ask some probing questions at the next meeting with your fund-of-funds manager."
- Cindy Koury
Senior Managing Director, Victory Capital Management

"Hedge fund expert Joe Nicholas dissects the industry's hottest trend, investing in fund of hedge funds, in his new book. It's a must-read for institutional and private investors alike."
- Joe Hershberger
Managing Director, Putnam Lovell NBF Securities Inc.

"Joe does it again! By taking complex and critical issues in hedge funds, he transforms them into the most accessible and readable form. Read it and reap."                                        - P. Morgan Kash
Senior managing director, Paramount Capital, Inc.
Board Member, Hedge Fund Association

"There has been tremendous growth in the fund of hedge fund business with assets doubling in the last year.  Joe clearly explains the reasons for this growth as he examines the hedge fund industry and assesses fund of hedge funds as the most effective way to gain exposure to the hedge fund arena. The book is a terrific resource for those considering an investment in hedge funds and/or a fund of hedge funds."
- Patricia Young
Managing Director and CIO, NewMarket Capital Partners, LLC

"Joe Nicholas has created an authoritative and innovative handbook of fund of funds investing that is essential for both financial and nonfinancial decision makers.  Building upon his previous writing, he has successfully applied his practical hands-on experience to demystify the hedge fund industry using common sense explanations that do not depend on obscure jargon or understanding."
- Sara Albrecht, CFA
Executive Committee and Trustee,  Museum of Contemporary Art, Chicago

Meet the Author

Joseph G. Nicholas, JD, is founder and chairman of HFR Group, LLC, which includes HFR Asset Management, LLC, a fund-of-funds management company, HFR Europe, Ltd, an investment advisory firm, and Hedge Fund Research, Inc., a leading supplier of hedge fund data. Author of Investing in Hedge Funds and Market-Neutral Investing, he is a frequent lecturer and media expert on topics relating to alternative investments.

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Hedge Fund of Funds Investing: An Investor's Guide 4.5 out of 5 based on 0 ratings. 2 reviews.
Anonymous More than 1 year ago
Guest More than 1 year ago
Joseph G. Nicholas' book is not for the faint of heart or the light of wallet. If your idea of a strong investment is a 401K plan and a few blue chip stocks handed down from your dear departed grandmother, this probably isn't the book for you. However, for those interested in how the very rich get very richer, as well as those charged with the weighty responsibility of protecting institutional and private assets, this book could be worth its weight in gold or stock certificates. Nicholas writes at a level that makes his information just comprehensible to those with minimal investment knowledge, while still very useful to insiders who know the menu of every deli within a two-mile radius of Wall Street. His in-depth historical analysis explains the current strong interest in hedge funds of funds investing, and his case studies will teach you the all-important matter of how to select the right fund of fund manager we strongly recommends this book to anyone who wants or needs to learn more about investing at the most elite levels.