Hedge Fund Investing: A Practical Approach to Understanding Investor Motivation, Manager Profits, and Fund Performance

Funds of Hedge Funds (FoFs)

Funds of hedge funds are diversified pools of capital designed to collect investments from smaller investors that can be aggregated and invested into a diversified portfolio of separate hedge fund managers and funds. During the growth phase of the industry, FoFs were extremely popular with HNWI and institutions that were first-time allocators to the hedge fund industry. They relied on FoFs to do research, allocate capital, gain access to managers, manage risk, and provide reporting that few investors could do on their own.

These FoFs have been around since at least the early 1970s, when Grosvenor Capital Management launched one of the first FoFs based in the United States. In the early years, the hedge fund and FoF industry was a cottage industry that primarily had HNWI clients. The main benefits of FoFs were providing diversification and access. Investing in an FoF gave investors exposure to a diversified group of funds without having to meet the investment minimums of each underlying hedge fund. Because hedge funds are typically structured as private placements not subject to SEC registration, there are limits on the number of investors a hedge fund can accept, and managers were constrained in their ability to publicize their strategies and track records. As such, there was no easy mechanism for identifying and tracking hedge fund performance. As such, FoFs could add value simply by developing an extensive database of funds for potential investment. ...