Chap 19 Funds of Hedge Funds

Question 1

Four functions of fund of funds management

Answer 1

1. strategic and manager selection
2. portfolio construction
3. risk management and monitoring
4. due diligence

S&M is PC with RMM and DD

Question 2

Four benefits to investing in FOF that may lead to higher net returns to limited partners without higher risk

Answer 2

1. economies of scale
2. informational advantage
3. access to certain managers
4. negotiated fees

EIAN

Question 3

Five benefits to investing in FOF that may lead to lower risk to limited partners without sacrificing expected return

Answer 3

1. regulation
2. educational role
3. currency hedging
4. diversification
5. liquidity

RECDL

Question 4

Describe the double layer of fees in FOF

Answer 4

FOF managers pass on to their investors all fees charged by the underlying hedge funds in the portfolios, while also charging an extra set of fees for their own work and an additional layer of service providers

Typically, FOF charge a 1% management fee and a 10% performance fee on top of the average underlying hedge fund management fee of 2% and incentive fee of 20% for the hedge funds

Question 5

Compare the volatility of:

• equally weighted portfolio of 16 uncorrelated, zero beta, equally risky funds
• a single such fund

Answer 5

• portfolio of 16 volatility would be reduced through division by the square root of the number of funds
  (i. e. division by 4 -> 75% risk reduction)

Question 6

Why incentive fees are different despite stated fees are similar:

multi strategy funds vs similar FOF

Answer 6

Multi strategy funds net the profits and losses of all underlying investment to determine any profit on which an incentive fee is paid.

FOF structure pay out inventive fees to each underlying manager separately –> more profitable managers receive full incentive fees - but there’s no offset to aggregate incentive fees due to the underlying managers with losses.

Question 7

What’s the difference in operational risks between:

multi strategy fund vs FOF

Answer 7

Multi strategy funds - single operational infrastructure
FOF - diversify risk across 10 - 20 independent managers and orgs

Market risk has more impact on multi strategy funds - may sink the entire fund if there’s catastrophic loss in one of the underlying strategies

FOF’s loss is limited to the loss of that particular manager (20 funds, 1 fund fails, 5% loss only)

Question 8

Define seeding fund

Answer 8

FOF that invest in newly created individual hedge funds, often taking an equity stake in the management companies of these new hedge funds.

Question 9

What investment pools in the US & EU provide liquid access of investors to alternative investment strategies?

Answer 9

US - some ‘40 Act funds

EU - UCITS

Question 10

Four major categories of FOF

Answer 10

1. market defensive
2. conservative
3. strategic
4. diversified

MCSD