CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

38.10 FUNDS OF FUNDS VERSUS INDIVIDUAL HEDGE FUNDS

One of the most important debates with respect to FoFs concerns whether they deserve their fees on fees and added value with respect to a randomly selected portfolio of, say, 20 to 40 hedge funds. In practice, there are essentially three ways for an FoF manager to add value:

1. Strategically allocate to various hedge fund styles. Running an FoF is not just simply a matter of assembling a large collection of good managers. Having such a collection can still result in a concentration of risks, with somewhat illusory diversification if there is a high level of correlation in the trades or underlying exposures of these managers. The first and most important choice that an FoF manager must make when organizing a portfolio is the long-term strategic asset allocation. This normally implies analyzing the long-term risk and return profiles of the different strategies, as well as examining the correlation of their observed and expected returns. The goal is then to determine an initial portfolio allocation consistent with the fund's long-term objectives and constraints. This task determines the long-run beta of the fund with respect to various sources of risks.

2. Tactically allocate across hedge fund styles. Tactical asset allocation refers to active strategies that seek to enhance portfolio performance by opportunistically shifting the asset allocation in response to the changing environment. Many FoFs argue that they follow a top-down ...