Fund of FundsHedge Funds
A Fund of Funds is a hedge fund which purchases stakes in other hedge funds. Managers divide money entrusted to them to investments based on their diversification benefits, risk levels, and anticipated performance. The fund’s alpha is earned based on the manager’s ability to appropriately select investment vehicles.
Fund of Funds: Benefits
Funds comprised of other hedge funds have a very obvious benefit: Massive diversification. These funds invest in hedge funds, each of which invests in a wide array of underlying assets. Literally any other investment category can be an underlying investment, since funds of funds invest in multiple strategies.
Fund of Funds: Negatives
Funds of funds have issues as well, primarily the total price. Each of the funds purchased by a fund of funds has its own expenses charged for investment. The fund of funds purchasing entry also has its own profit sharing and percentage of assets under management costs. This results in multiple layers of expenditures.
This additional layer of fees eliminates more of the profit that you would otherwise get to keep. This extra layer of fees increases losses and reduces profits. If an investor in a fund of funds were to hold each hedge fund separately, they would pay less in fees and expenses than through the fund of funds. This strategy would be difficult to implement. All hedge funds have minimum balances which allow them to avoid regulatory oversight by only accepting accredited investors. A fund of funds can consist of dozens or hundreds of individual hedge funds, attempting to mimic a fund of funds will result in your portfolio rapidly becoming mostly or entirely hedge funds. Since hedge funds should only hold excess capital due to their cost, pursuing an emulated position for funds of funds is highly unreasonable.
A fund of fund’s asset under management and performance fee is indirectly the cost of bypassing the stacking minimum balances which would be required to diversify across so many funds. You are additionally paying for the fund manager’s supposed expertise at predicting long term performing funds. This does not mean investment in funds of funds is worthwhile after costs. This does not necessarily make funds of funds a wise investment. Losing large amounts of your returns to combined profit sharing and assets under management charges is not a good way to generate investment earnings.
Fund of Funds: Potential Investment Overlaps
A very minor issue of funds of funds is overlapping investments. Since each fund makes its own selection of investments, and so many funds have been condensed into one fund, you have absolutely no control over the same investments being held by several funds and your portfolio. Overlapping investments will magnify your gains and increase your losses. Your funds of funds will provide substantial diversification but you should remain aware that overlaps will slightly reduce actual diversification.
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