The Little Book of Hedge Funds

Chapter Nine

The Men Behind the Curtains

Fund of Hedge Funds

A fund of funds due to the fees involved will, over time, underperform the ETF on the S&P 500. I’ll betcha.

—Warren Buffett (well, not really)

Okay. Warren buffett never uttered the words above, but he may as well have. In 2008, the Oracle of Omaha bet Protégé Partners LLC—a money management firm that runs a fund of hedge funds—that the returns from a low-cost S&P 500 Index fund sold by Vanguard will outperform the average returns delivered by 5 fund of hedge funds (net of fees, costs, and expenses) over 10 years. Having put up roughly $320,000 on each side, this winner-takes-all wager is serious business. Although the 2007 to 2009 economic crisis put Buffett behind, he is now closing the gap. But, the fact remains that many people question the validity of this alternative investment vehicle that provides investors with access to the historically inaccessible world of hedge funds and their legendary managers.

So, what is a fund of hedge funds? As the name implies, it is a fund that invests in other hedge funds. In creating and managing a portfolio of various hedge funds, a fund of hedge funds manager thematically blends together funds so as to maximize returns while minimizing risk. To do so, he must create a diversified portfolio that is composed of funds that exhibit low correlations with the overall market, experience solid performance, and have lower volatility. Thus, funds of hedge funds are the ultimate vehicle ...