Chapter 21 CAIA Flash Cards - Funds of Hedge Funds
Four Functions of Fund of Funds Management
STRATEGY AND MANAGER SELECTION
PORTFOLIO CONSTRUCTION
RISK MANAGEMENT AND MONITORING
DUE DILIGENCE
STRATEGY AND MANAGER SELECTION
The FoF manager is responsible for selecting the strategies and the managers who will implement those strategies. FoF managers may have access to closed managers as well as insights regarding strategies that are likely to perform better going forward. Many of the largest institutional investors and their investment consultants have teams dedicated to finding, vetting, and investing directly in hedge funds.
PORTFOLIO CONSTRUCTION:
Once the strategies and managers have been selected, the FoF manager has to decide on how much to allocate to each strategy and manager. The allocation will depend on the risk and return characteristics of the individual managers and the expected correlations between funds, as well as other fund features, such as the lockup period, the liquidity of the positions, the size of the fund, and the length of each manager’s track record.
RISK MANAGEMENT AND MONITORING
The FoF manager will monitor each hedge fund to ensure that its ongoing performance profile is consistent with the fund’s overall objectives. Some FoFs employ sophisticated risk-management processes to monitor the underlying hedge funds’ positions. Other FoFs may employ multifactor sensitivity analysis to gauge the risk exposure to various market factors and to analyze the funds’ potential tail risk.
DUE DILIGENCE
For hedge fund investing, due diligence is the process of monitoring and reviewing the management and operations of a hedge fund manager. This is perhaps one of the more important functions and value-added features of an FoF manager to consider when deciding between a direct and a delegated hedge fund investment program. Unfortunately, some of the large FoFs have been marred by blowups and fraud scandals, which have caused some institutional investors to become wary about the value of an FoF’s due diligence process. There is, however, some academic evidence justifying the payment of an additional layer of fees in return for operational due diligence. Operational due diligence is the process of evaluating the policies, procedures, and internal controls of an asset management organization. Brown, Fraser, and Liang1 estimate that net of fees, the largest FoFs tend to outperform the smallest FoFs. Larger FoFs may outperform because their scale allows them to invest greater resources in due diligence and risk management processes.
Eleven Benefits to Investing in Funds of Funds
DIVERSIFICATION
ACCESSIBILITY
ECONOMIES OF SCALE
INFORMATION ADVANTAGE
LIQUIDITY
ACCESS TO CERTAIN MANAGERS
NEGOTIATED FEES
REGULATION
CURRENCY HEDGING
LEVERAGE
EDUCATIONAL ROLE
DIVERSIFICATION
DIVERSIFICATION: Prudent investing dictates that portfolios be well diversified. Some investors lack the necessary asset size and expertise to invest directly in hedge funds to reach an appropriate level of diversification and risk reduction. By contrast, through a single FoF investment, investors can access a well-diversified portfolio in terms of managers or strategies. However, the diversification level of an FoF portfolio is not necessarily a straightforward function of the number of underlying funds or strategies analogous to stock investing. This is because hedge funds are not single securities; rather, they are previously diversified portfolios of securities.
ACCESSIBILITY
ACCESSIBILITY: The median minimum investment for a single hedge fund is $500,000, which makes diversification into numerous funds unaffordable for most individual investors. By comparison, minimum investment levels for FoFs are relatively low. This allows more individual investors and small institutions to gain diversified access to hedge funds even though their capital base is comparatively small.
ECONOMIES OF SCALE
ECONOMIES OF SCALE: Investors essentially share costs, such as those associated with the manager selection, reporting, analysis, and due diligence processes, with their FoF co-investors, thereby reducing their individual costs.
INFORMATION ADVANTAGE
INFORMATION ADVANTAGE: As professional asset allocators, FoF managers have the ability to access, collect, and interpret data gleaned from various channels, such as data providers, prime brokers, and industry contacts. This gives them an informational advantage over nonprofessional investors.
LIQUIDITY
LIQUIDITY: Investments in hedge funds are relatively illiquid, due to lockups, potential redemption gates, notice periods, and limited redemption dates. By comparison, the liquidity terms offered by FoFs are typically more flexible. Most FoFs offer quarterly or monthly liquidity in normal market conditions. Some FoFs even offer daily liquidity, either through a listing on an exchange or via an over-the-counter secondary market that matches demand and supply.
ACCESS TO CERTAIN MANAGERS
ACCESS TO CERTAIN MANAGERS: Access to the best talent and ideas in the hedge fund community is a scarce resource. The most desirable hedge funds may be closed to new investments. Many investors do not have the necessary networks and protocol for obtaining investment capacity in these funds when it becomes available. Investing in an existing FoF that is already allocated to these desirable hedge funds is the fastest way to immediately participate in their performance.
NEGOTIATED FEES
NEGOTIATED FEES: Thanks to the power of their collective assets, some FoFs have successfully negotiated access to certain managers at reduced fees. This is normally beyond the capabilities of most individual investors.
REGULATION
REGULATION: In order to facilitate their distribution to a wider audience, some FoFs choose to register in regulatory jurisdictions that offer better investor protection than their underlying investments, even though the cost and administrative and operational burdens may be higher. The improved investor protections can often be reassuring for first-time investors and can ensure that they will receive sufficient transparency, oversight, and quarterly reports.
CURRENCY HEDGING
CURRENCY HEDGING: Although the currency of choice in the hedge fund world is the U.S. dollar, some FoFs offer share classes denominated in various currencies with the currency risk hedged. Whereas institutional investors often wish to manage their own currency risks, many small or private investors prefer to be shielded from currency fluctuations and thus delegate the hedging aspects to professional managers.
