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

Unique Opportunities and Risk Associated with Fund of Funds

Funds of funds can deliver significant benefits to investors. They can be used to quickly gain exposure to the asset class or to a customized sector of the hedge fund landscape. The research and databases maintained by FoFs on individual managers would be difficult, if not impossible, for most investors to maintain on their own. Despite the higher costs, many investors who are new to hedge funds choose to start with an FoF product and then later diversify to individual managers or a multistrategy fund.

Some of the more significant risks that are present in many FoFs can also be avoided by investors who perform adequate due diligence on the provider prior to investing. A few of the more serious risks that investors need to evaluate in FoF are discussed next.

One risk is the degree to which an FoF analyst or portfolio manager has direct access to the decision maker and portfolio characteristics at any point in time for each specific hedge fund in the portfolio. This access to people and information varies from firm to firm. Firms that have regular contact with the senior officials at the underlying hedge fund and get full transparency are in a position to add more value and respond to a market crisis than those who find themselves meeting only with the investor relations team at a hedge fund or other middle-level managers and getting information on the portfolio no more than once a month on a delayed basis. Investors should ...