What is a Fund of Funds – and why invest in them?
Like a stack of Oreos rather than just one, a Fund of Funds is an investment product made up of various hedge funds – rather than just one cookie.
But how do asset managers and financial advisors explain – in person, on your website, and in other communications – the potential advantages of investing in a Fund of Funds versus investing in a single or small group of hedge funds?
Here are five points to put in your communications with potential investors:
1. Instant Diversification
Fund of Funds provide instant diversification for an investor’s hedge fund allocation and the opportunity to reduce the risk of investing with a single fund manager. While individual hedge funds often focus on a specific strategy or market, Fund of Funds may hold anywhere from three to 30 funds in their portfolio, with dramatically different strategies.
With a Fund of Funds, investors with limited capital can access a number of fund returns with one investment, achieving instant diversification. Rather than assuming the risk of selecting one individual manager, the Fund of Funds provides a portfolio of managers with a single investment.
2. Lower Investment Minimums
The median single manager managed futures hedge fund in Morningstar’s database required a $250,000 initial investment, while the median hedge fund of funds may need only $50,000.
3. Built In Due Diligence
As a fund of fund manager, you are your investor’s proxy for hedge fund due diligence, performance verification, and background check.
4. Lower Volatility
The fund selection process can provide lower volatility – and greater stability – of returns by spreading assets over a broader range of strategies.
5. Fewer and Smaller Drawdowns
In addition, significant drawdowns have historically been mitigated by owning a portfolio of companies in a Fund of Funds. According to Jack D. Schwager in his book Market Sense and Nonsense, the standard deviation of the HFR Fund of Fund Index in 2012 was consistently smoother than the S&P 500 Index, at 6% versus 15%.
Higher Fees and Expenses
The cost of investing in a Fund of Funds is of course potentially higher than for individual hedge funds. Fees include the Fund of Fund management and performance fees, plus the management fees of the underlying funds.
How then do investment managers answer the question of higher fees versus individual hedge funds? The answers are in the points above: instant diversification, lower investment minimums, potentially lower volatility, and fewer and smaller drawdowns.
Another drawback to many Fund of Funds is stock overlap. The Fund of Funds may end up owning the same security in several different funds. While this may reduce your potential diversification, you might point out that the size and scope of the stock overlap is small, or that the multiple positions reflect high conviction in one security.
Important Risk Disclosure For Alternative Investments
What goes in all of your communcations to the public? Not surprisingly, it this: Past performance is not necessarily indicative of future results. Futures investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.
Also note that most hedge fund investors (and fund of fund investors) must meet accredited investor requirements: individuals need a net worth of $1 million, excluding their primary residence, or total income exceeding $200,000.
How do you inform and educate your prospects on the potential benefits of the Fund of Funds asset class? The short answer is inbound marketing – content that seeks to illuminate when your clients are ready, via a series of eBooks, email marketing campaigns, blog posts, pitch books, fact sheets, videos, and other marketing tools in your toolbox.