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Hedge Fund Of Funds InvestingAn Investor's Guide
By Joseph G. Nicholas
Bloomberg PressCopyright © 2004 Joseph G. Nicholas
All right reserved.
Chapter OneFund 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.
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.
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.
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.
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