Funds of hedge funds are considered less risky than alternative investment strategies. For example, FoHF managers can freely select the portfolio strategies they use. FoHF managers are therefore able to allocate their funds to a single strategy (single-strategy funds of hedge funds) or to various strategies (multistrategy funds of hedge funds).
Worldwide, the number of FoHFs has increased dramatically over the last decade. In 1990, according to hedge fund research (HFR), there were about 80 FoHFs; by 2000, that number had increased to 538.
By the end of 2006, the amount had more than quadrupled to 2221, primarily due to high demand from institutional investors who prefer FoHFs for their first hedge fund allocation. About 70% of FoHFs use leverage, but mainly to finance backup solutions, not for investment purposes. Figure 1 shows the typical investment process of a FoHF.
We can classify FoHFs according to their management concepts into the following industry typical classes:
- Index concept
- Qualitative concept
- Quantitative concept
Funds following the index concept invest in up to 100 individual hedge funds, with the aim of tracking the risk/return profile of the entire hedge fund field. Managers using this concept believe their selection skills will lead to long-term outperformance and minimize blow-up risk. The index approach is characterized by simplicity, clear investment rules, and significant diversification to safeguard investors from managerial risks.
Funds following the quantitative concept, hold up to 50 funds, and attempt to quantify their weight and style allocations based on models. Many statistically uncorrelated hedge funds may thus be combined in one portfolio. Quantitative managers try to generate additional value through selection and active optimization of different hedge fund style allocations.
The qualitative concept is characterized by limiting the portfolio to a maximum of 20 hedge funds selected through thorough due diligence and rigid qualitative monitoring of portfolio positions.
Managers following this approach do not see any additional value in past hedge fund performance. They aim to generate value by sound diversification of different performance strategies. Due diligence and monitoring, however, are large expenses for these managers.
Lhabitant and Learned (2003) note that most funds of funds hold between 15 and 40 underlying hedge funds, but a portfolio consisting of 5–10 would provide most of the diversification benefits.
Lhabitant (2006) also shows that as the number of hedge funds increases, the beta of the portfolio also increases. Kat (2004) shows that FoHFs provide skewness protection while offering diversification through a basket of hedge funds.
Subscription and exit solutions are possible in the hedge fund universe on at least a monthly basis. Fothergill and Coke (2001) have shown that most FoHFs do not charge an entry fee. However, if third parties such as brokers or banks are involved in the sale of shares, there is usually a sales fee and a yearly performance fee.
Hedge fund lock-up periods, during which investors cannot take money out of the fund, must also be considered by investors. According to an AIMA study, 70% of FoHFs require a lock-up period of at least 6 months. The other 30% usually have an individual lock-up period. The minimum investment in a FoHF ranges from U.S. $50,000 to $250,000.
One of the major disadvantages of investing in FoHFs is the additional fee level compared to an allocation in single hedge funds. Typically, FoHFs charge a combination fee, consisting of either a 1.5% management fee with no performance fee, or a 1.0% management fee combined with a 10% performance fee.
We assume that the pressure on FoHF fees will increase in the coming years, and we expect they will ultimately decrease to a management fee of between 0.70 and 1.00%, with no performance fee.
The literature thus far has found mixed results regarding FoHF performance versus individual hedge fund performance. Brown et al. (2004), for example, find that individual hedge funds dominate funds of funds on an after-fee return basis or a Sharpe ratio basis.
Based on an empirical analysis of 907 FoHFs, Capocci and Hübner (2006), however, find empirical evidence of performance persistence, and show that the Sharpe ratio is the most suitable measure.
According to Fung and Hsieh (2000), FoHF performance does not depend on various biases (survivorship bias, self-selection bias, instant history bias) because
- they also include hedge funds, which are not found in any database,
- they feature data on hedge funds that have ceased to operate, and
- their historical track records do not include the performance of any new funds they may have invested in.
The market for FoHF can be divided into small (up to U.S. $500 million in assets under management [AUM]), medium ($501 million to $1 billion AUM), and large (over $1 billion AUM). The large category only comprises about 10% of all FoHFs.
Risk-averse investors tend to invest in large funds of funds with a high degree of diversification. Investors aiming for high returns or an outperformance of strategy indices may opt for smaller, specialized funds of hedge funds.
The large fund of funds model has the following advantages:
- Investment resources to select and analyze managers from a large database
- The potential to diversify by selecting various managers
- A better negotiation position for individual hedge fund fees
- The capital to equip new managers with seed money
- Decreasing fixed administration costs
- Lower entrepreneurial risk for investors
The advantages of FoHFs generally are their established market reputation and long track record based on long-term hedge fund investment. However, there are several disadvantages that should not be ignored, such as:
- Difficulty in optimally allocating large sums of capital
- Potentially suboptimal manager allocation to guarantee future investment capacity
- A tendency to overdiversify
- Difficulty in actively allocating within specific strategies
- A practical inability to invest in niche strategies or very tight strategies (quasiclosed)
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