Funds of Hedge Funds
Funds of hedge funds are some of the more recent additions to the investment market. They also comprise one of the fastest growing investment areas in terms of both total assets under management and numbers.
Funds of hedge funds are exactly what their name implies. They are funds that have been organized mainly for the purpose of investing in hedge funds - thus they are funds composed mainly of hedge fund investments. Since funds of hedge funds are primarily concerned with hedge fund investments, investors must learn more about hedge funds before they invest in a fund of hedge funds.
Funds of Hedge Funds versus Hedge Funds
A fund of hedge funds is a single fund that is made up of uncorrelated private hedge funds. In other words, it is a fund that is invested mainly in hedge funds. A fund of hedge funds can be geographically focused, sector focused or diversified.
A hedge fund, on the other hand, is invested in securities. They function more like mutual funds in the sense that they pool investors' money and invest the accumulated amount in a variety of equity and bond instruments.
Like hedge funds, funds of hedge funds are generally unregistered with the SEC. However, SEC-registered funds of hedge funds do exist. Funds of hedge funds also generally have lower investment requirements and can take on a greater number of investors than typical hedge funds.
Like hedge funds, funds of hedge funds also employ sophisticated (and sometimes) risky investment strategies to achieve its aim of gaining consistent and predictable returns regardless of market conditions. As such, both hedge funds and funds of hedge funds are generally preferred by sophisticated investors, wealthy individuals, endowments, insurance companies, and private banks.
Investing in a fund of hedge fund, however, may offer investors some advantages over investing directly in private hedge funds. For one, a fund of hedge funds has a greater capacity and ability to diversify its investments, its investment strategies and its market focus. After all, it is a collection of hedge funds, each of which is individually managed and practices a different investment strategy.
The Advantages of Investing in a Fund of Hedge Funds
What are the benefits of investing in a fund of hedge funds instead of other investment instruments?
- Similar to investing in private hedge funds, investing in funds of hedge funds gives you the advantage of possible gains, regardless of actual equity and bond market performance.
- Managers of funds of hedge funds' usually have great expertise and their sophisticated hedging strategies enable funds of hedge funds to deliver a more consistent and predictable rate of return than traditional investment vehicles like stocks, bonds and mutual funds.
- The diversification inherent in funds of hedge funds reduces the perceived risks of direct hedge fund investment. This greatly reduces the impact of a single hedge fund manager's mistakes on investors.
- The diversification inherent in funds of hedge funds also make due diligence and investment management easier for investors.
- Funds of hedge funds also enable investors to take part in premium private hedge funds that may otherwise be unavailable to the public. Investors are thus exposed to a wider range of strategies, products, and markets.
The Disadvantages of Investing in a Fund of Hedge Funds
The following are some of the disadvantages of investing in funds of hedge funds:
- High Costs: Funds of hedge funds are some of the most actively managed investment vehicles in the market. Their underlying investments - the hedge funds in which funds of hedge funds are invested - are also some of the most actively managed investment funds in the market. Thus, funds of hedge funds are some of the most expensive investments available in terms of annual fees and performance fees on profits. An annual asset base fee of 2.15% and a performance fee of 10% on gains above 8% is perfectly possible among funds of hedge funds.
- High-Risk Investing Strategies: Although funds of hedge funds seek to maintain a consistent and predictable level of returns for their investors while maintaining risks at a tolerable level, the inherent risk in using speculative and sophisticated trading and investment strategies may be enough to wipe out an investor's entire investment.
of Investor Protection: A fund of
hedge funds may be unregistered, in which case it doesn't have to comply
with SEC's reporting requirements. Investors, therefore, have no ready
access to information about this fund.
- Even if a fund of hedge funds is registered with the SEC, its underlying investments (i.e. hedge funds) are probably unregistered. In that case, the fund itself will find it harder to find timely and relevant information about its hedge fund holdings that could mean the difference between a wise and a foolish investment decision.
- To put it simply, funds of hedge funds do not offer investors the same level of protection and the same amount of information as do traditional investment options like stocks, bonds and mutual funds. This lack of information and protection makes it harder for investors to evaluate funds of hedge funds' performance. They also make investors more vulnerable to fraud.
- Liquidity Issues: The hedge funds underlying funds of hedge funds are unregistered and highly illiquid. Thus, funds of hedge funds investors may also experience liquidity issues.
- Tax Issues: The tax structures of registered funds of hedge funds are a lot more complicated compared to traditional investment options like mutual funds. Due to possible delays in receiving important tax information, investors of funds of hedge funds might need to apply for a tax filing extension.
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