Fund of Funds Investing: A Roadmap to Portfolio Diversification

Chapter 13. Multi-Strategy Funds versus Hedge Fund of Funds

If you ask seasoned hedge fund investors what keeps them awake at night, with very few exceptions you will get the same answer: the possibility of a massive drawdown. Such a drawdown can be classed into two broad categories: those related to poor portfolio management and trading decisions, and those caused by some exogenous factor outside the portfolio management process. To successfully navigate the universe of hedge fund investing, sophisticated investors have developed procedures to determine whether a drawdown could take place at a given hedge fund at any given time based on any given situation.

Despite the passage of time and the occurrence of other well-known blowups, hedge fund investors are still feeling the aftermath of the collapse of Amaranth in 2006 and the subsequent market meltdown in which some of the industry's greatest names went down 10, 20, or even 30 percent in 2008. As a result of these losses, many hedge fund investors are once again asking questions about the optimal investment vehicle to provide portfolio diversification. Many answers come down to two choices—fund of funds or multi-strategy funds.

DRAWDOWN ISSUES

Given the large pools of capital coming into the hedge fund industry, hedge fund investors proudly flaunt their unique due diligence processes and their ability to detect signs that a drawdown may occur. Sophisticated investors view the massive drawdown as an uncommon occurrence that their ...