CAIA Level I: An Introduction to Core Topics in Alternative Investments, 2nd Edition

CHAPTER 17

Funds of Hedge Funds

The last six chapters have described the universe of hedge funds and its constituent categories of event-driven, relative value, macro, and equity strategies. Few investors allocate their entire hedge fund investment to a single hedge fund manager or even a single hedge fund strategy. Investors realize that each manager and each strategy has its own specific risks and cyclicality of returns and that diversification across managers and strategies can reduce the risks of hedge fund investing.

The hedge fund industry includes funds of funds as well as single manager funds. Funds of funds are hedge funds with an underlying portfolio of other hedge funds. The primary advantages of a fund of funds are diversification, professional manager selection, and portfolio management processes. The primary disadvantage of a fund of funds is a second layer of fees imposed by the fund of funds manager. There are also multistrategy funds that are simply individual hedge funds that diversify into a variety of investment strategies rather than focus on a single strategy.

17.1 BENEFITS AND COSTS OF DIVERSIFICATION

The benefits of holding a diversified portfolio of assets result from correlations among asset returns being less than 1, meaning that returns are not perfectly positively correlated. Exhibit 17.1 shows that there have been modest correlations across hedge fund strategies, ranging from 0.327 between macro and relative value to 0.827 between event-driven and ...