Funds of Hedge Funds

Question 1

1. List the four functions of fund of funds management.

Answer 1

• Strategic and Manager Selection
• Portfolio Construction
• Risk Management and Monitoring
• Due Diligence

Question 2

2. Name four benefits to investing in funds of funds that may lead to higher net returns to limited partners without causing higher risk.

Answer 2

• Economies of Scale
• Informational Advantage
• Access to Certain Managers • Negotiated fees

Question 3

3. Name five benefits to investing in funds of funds that may lead to lower investment risk to limited partners without sacrificing expected return.

Answer 3

• Diversification
• Liquidity
• Regulation
• Currency Hedging
• Educational Role

Question 4

4. Describe the double layer of fees in funds of funds.

Answer 4

• FoF managers effectively pass on to their investors all fees charged by the underlying hedge funds in their portfolios, while also charging an extra set of fees for their own work as well as for an additional layer of service providers.
• Many FoFs 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

5. In theory, how would the volatility of an equally-weighted portfolio of sixteen uncorrelated, zero-beta and equally-risky funds compare to the volatility of a single such fund?

Answer 5

• The volatility of an equally-weighted portfolio of sixteen uncorrelated, zero-beta and equally- risky funds would be reduced (as shown in Equation 21.1) through division by the square root of the number of funds (16). Division by four generates a 75% risk reduction.

Question 6

6. Why might the incentive fees of a multistrategy fund differ substantially from the incentive fees of an otherwise similar fund of funds even if the stated fees are equal?

Answer 6

• Multistrategy funds net the profits and losses of all underlying investment to determine any profit on which an incentive fee is paid. Funds of funds structures pay out incentive fees to each underlying manager separately, meaning that the profitable fund managers receive full incentive fees but there is no offset to aggregate incentive fees due to underlying managers with losses.

Question 7

7. Why might the operational risks of a multistrategy fund differ substantially from the operational risks of a fund of funds?

Answer 7

• While funds of funds diversify operational risk across 10 to 20 independent managers and organizations, a multistrategy fund has a single operational infrastructure. Market risk may also be a concern, as a catastrophic loss in even one of the multistrategy fund’s underlying strategies may sink the entire fund. Conversely, the failure of one of a fund of funds’ 20 managers may subject investors to only a 5% loss and not affect the fund’s other investments.

Question 8

8. What is a seeding fund?

Answer 8

• Seeding funds, or seeders, are funds of funds that invest in newly created individual hedge funds, often taking an equity stake in the management companies of the newly-minted hedge funds.

Question 9

9. What investment pools in the US and Europe provide liquid access of investors to alternative investment strategies?

Answer 9

•UCITS in the EU and some ’40 Act funds in the U.S.

Question 10

10. List the four major categories of funds of funds.

Answer 10

• Market-Defensive Fund of Funds
• Conservative Fund of Funds
• Strategic Fund of Funds
• Diversified Fund of Funds