Manager risk represents a significant problem for hedge fund investors. Not only is there great variation in performance across managers, but there is also the risk that managers might blow up. So many investors have chosen to diversify the manager risk by investing through a fund of hedge funds. Figure 9.2 shows that 24 percent of the hedge funds in the TASS database are funds of hedge funds.

What advantages do fund of funds offer to the investor? There are two major advantages. First, the funds of funds offer due diligence and expertise in choosing hedge funds. With about 10,000 hedge funds to choose from, many of which have short track records, it’s difficult for an investment advisor to make decisions about which funds to invest in. A fund of funds offers a group of recommended hedge funds that the fund of funds manager has investigated. And a fund of funds manager should be able to constantly monitor the hedge funds that are chosen in case there are changes in personnel or other material changes in operations. Due diligence by the managers of the funds of funds will not ensure against blow ups, but probably reduces their number.

The second advantage of the fund of funds lies in the diversification of manager risk. As with all assets, investing in 15 managers rather than two managers undoubtedly reduces risk. Just as importantly, a fund of funds can give the investor diversification across hedge fund styles. So if convertible arbitrage falls out of favor, perhaps ...

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