Hedge funds are loosely regulated investment funds that allow private investors to pool assets to be managed by an investment management firm. These funds are different from each other in their approaches and objectives, and hence they show varying levels of return and risk.
The strategy of a hedge fund can fall under several categories such as tactical trading, equity long/short, event-driven, and relative value arbitrage, with equity long/short strategies being the dominant strategy as of 2006.
An alternative to investing in a single-strategy hedge fund is the investment in a portfolio of hedge funds, a multi-strategy fund, to maximize return for a given level of risk. In this portfolio of hedge funds, called funds of hedge funds or funds of funds, an investor will have access to several managers and several investment strategies through a single investment.
A small drawback of investing in FOFs is the second layer of management and performance fees that compensate for the FOF manager’s expertise in identifying the best hedge fund managers for the portfolio. To diversify the portfolio risk, a funds of fund manager—a multi-strategy fund of funds—may allocate investment capital to several managers with different strategies.
In other words, a multi-strategy fund of funds incorporates various single strategies (not necessarily offered by the same organization) to diversify across strategies. A multi-strategy hedge fund can also be created by the various single-strategy hedge funds of ered within the same organization.
Through a multi-strategy fund, an investor can have higher returns and lower risk through strategy optimization (i.e., allocation of fund capital among strategies), can invest in hedge funds closed to new investors, can invest with a lower investment size, and can lower search/time cost of selecting the right manager/strategy at the cost of higher fees and possibly for moderate returns relative to a single-strategy fund.