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 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.
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 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 Portofolio
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.
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This is a great book for anyone who has even a little uncertainty about the operations and/or the investment selection of FOFs. As a recent Wharton MBA myself, I know that many of these topics are not covered in classical investment training - it's just too recent of a trend. But FOFs are an explosive trend - with nearly 1/3 of all hedge fund investments - and one that all investors need to understand. Mr. Nicholas's book does an outstanding job in providing this background on the fundamentals of FOF investing.
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