Hedge funds - 2

Fund of funds investing;

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LOS
j. explain the benefits and drawbacks to fund of funds investing;
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Fund of funds have been created in hedge funds.

A fund of funds collects money from small investors and in turn invests in various hedge funds.

It provides investors with the following benefits.

Retailing
As noted earlier, hedge funds requier minimum $200,000 per investor. In the case of fund of funds for the same amount, the investor can get exposure to a large number of hedge funds.

Access

FOF managers can invest in highly successful hedge fund which are closed for subscription as old (existing) investors. Because of their relationships, they can buy partnership or shares of investors leaving the hedgefunds.

Diversification
This benefit is similar to the retailing benefit. In the case of retailing even person with minimum amount gets the benefit of diversification. But in this case benefits of diversification are emphasized for even big investors.

Expertise
The fund managers of FOFs have and develop expertise in finding good quality hedgefunds. Information about hedge funds is limited as they do not advertise. FOF managers buy databases and develop more intimate knowledge of strategies, and their advantages and potential pit falls.

Due Diligence process
There is a due diligence process which needs to be done. Individual investors will find it difficult to do. Even institutional investors may find it cumbersome. An FOF can have better staff resources, procedures and systems to perform the due diligenc process compared to typical institutional investors.

Drawbacks

Fee: Additional fee to FOF managers.
While each hedge fund in which FOF invests charges its fee, FOF charges an additional fee on the AUM. So investors in FOF have to pay an additional fee.

Performance: Past performance based selection is generally done by FOFs. There is little scientific evidence of persistence of performance delivered by FOFs.

Diversification - a two edged sword: Due to diversification FOFs may invest in some high performing funds and some not so high performance funds. So the realized return can be lower than the return of high performance funds.