Funds of Hedge Funds offer a professional service in manager selection, due diligence process and portfolio management. Of course this service comes at a cost, and that is on top of the standard 2 and 20 you are already paying for Hedge Fund investments.

Standard FoHF fees are on the decline, as there is more competition, but it is still close to 1 and 10.
Some argue that the extra level of fees reduces performance of the portfolio to a point where it does not compensate to invest your Hedge Fund portfolio through a FoHF.

HF AUM by Strategy Q3v 2015Source Barclayhedge

The above pie chart shows just how well the Hedge Fund universe is divided across various strategies. Choosing the right strategies that best suits the macroeconomic regime as we move forward and that fit your needs may also be more than good enough reasons to invest with FoHFs.

Why pay extra fees for a Funds of Hedge Funds?

Manager selection can be costly and take away time and resources for an individual investor. You may also not be in the position to access all the information you need from a manager who may only be willing to interact at a certain level of disclosure with institutional clients. These clients are the ones that are investing large amounts of cash and will only do so if they have enough information.

You may also find it hard to spread your HF allocation across enough managers and strategies due to the size of their minimum investments. This can lead to you being invested in 1 or 2 funds which is probably not the best way to reduce risk in a high risk asset class.

FoHF therefore because of their size can perform the necessary due diligence and portfolio management. They will also be able to create a portfolio with a large enough number of HFs spread across managers and strategies. This will greatly reduce the overall risk of your HF portfolio.

 Why the need to hold many Hedge Funds?

It has been shown that correlations between assets that are lower than 1 reduce the risk of a portfolio. This is known as a benefit of diversification which arises when assets that do not have perfect correlation are held in a portfolio. HF strategies also have correlations that are lower than 1, in some cases considerably lower. It is reasonable to believe therefore that holding a portfolio of HFs with different strategies will greatly reduce the total risk of your HF portfolio.

Strategy Correlations
Data source CAIA Body of Knowledge

Risk in this case is measured as the standard deviation of returns, also known as volatility. We are usually told that less risk equals less return. However in the case of a diversified portfolio less risk may not necessarily equal less return.

To see the effect consider there are two portfolios each with one asset A and B. Each asset has a return of 10% and a standard deviation of 10% and a correlation of zero. Now if we put the two assets into one portfolio the combined standard deviation must be less than 10% as there is no correlation whatsoever, it would be reasonable to assume that these to assets will not underperform at the same time. In other words a combination of these two assets has to be less risky than a portfolio of 1 asset. Looking at return we see that 10%+10% / 2 will still give us a 10% return. We have therefore not lost any return potential but we have potentially reduced overall risk.

 The other option is Multi-strategy Funds

Another option is to invest in Multi-Strategy Hedge Funds, these funds implement a variety of strategies. They also benefit to being able to allocate funds to the strategies that look to be the most promising in terms of performance. If they have a view that Fixed Income Arbitrage may benefit from a higher interest rate environment they may allocate more capital to that strategy. They therefore have similar flexibility to a FoHFs in choosing which strategies to allocate to and they usually have various operating within one fund.

These funds may offer strategy diversification and be agile in switching in and out of the more profitable ones, but they lack manager diversification. In the end you are still putting all your eggs in one basket, unless you have enough capital to allocate to HFs that you may be able to invest in several Multi-Strategy managers. In this case you will simply have the burden of executing several due diligence processes and maintaining your portfolio.

Which investment choice is right for me?

Bottom line comes down to how much is it going to cost in time and effort to go through the due diligence necessary to choose a portfolio of managers? Are the investments for each fund going to be big enough to access all the necessary information and achieve a high enough level of disclosure?

You may well find that your investment in Hedge Funds may be managed in a more efficient and productive way if in the hands of professional fund manager. A FoHF will have the necessary capital to obtain the highest possible level of disclosure along with the resource to perform effective due diligence and continued portfolio management.

Hedge Fund managers are often also very keen in maintaining investments from FoHFs as these investors have a level of knowledge and experience that will usually allow for an enhanced interaction between the two parties. If you are not looking to hold a portfolio of HFs and are seeking a high risk high return investment by allocating to one or two Hedge Funds, then FoHFs will probably not suit you. FoHFs would not hold enough risk and may see outperforming returns capped as total portfolio return is spread across many funds, therefore diluting the performance of the best funds.

Gino D'Alessio, CAIA

Gino D'Alessio is a Broker/Dealer with over twenty years experience in various OTC markets such as Bonds, FX and Derivatives. Currently a Financial Markets and Investments Writer & Analyst
Gino D'Alessio, CAIA