Browse Analysis of Managed and Structured Products

20.4.5 Funds Of Hedge (or Liquid Alts) Funds

Explore the structure, advantages, and disadvantages of Funds of Hedge Funds (FoHF) and Liquid Alternative Funds, understanding their role within Canadian investment portfolios.

20.4.5 Funds Of Hedge (or Liquid Alts) Funds

Funds Of Hedge (Or Liquid Alts) Funds

Both hedge funds and liquid alts are able to invest up to 100% of their net assets in other mutual funds, including alternative mutual funds, establishing a fund-of-funds structure. For the purpose of explanation, we refer below to this structure as a fund of hedge funds (FoHF), but it can just as easily be a fund of liquid alt funds.

An FoHF is a portfolio of hedge funds overseen by a manager who determines which hedge funds to invest in and how much to allocate to each.

Types of FoHF

  1. Single-strategy, multi-manager funds: These funds invest in several funds that employ a similar strategy, such as long or short equity funds and convertible arbitrage funds.
  2. Multi-strategy, multi-manager funds: These funds invest in several funds that employ different strategies.

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Advantages of Funds Of Hedge Funds

Funds of hedge funds offer several key benefits:

Due Diligence

The task of selecting and monitoring alternative fund managers is time-consuming and requires specialized analytical skills and tools. Most individual and institutional investors do not have the time or expertise to conduct thorough due diligence and ongoing risk monitoring for hedge funds. An FoHF provides an effective way to outsource this function.

Reduced Volatility

By investing in a variety of hedge funds, an FoHF should deliver more consistent returns with lower volatility and risk than that of its underlying funds.

Professional Management

An experienced portfolio manager and their team evaluate the strategies employed by the various fund managers and establish the appropriate mix of strategies for the fund. Selecting funds that make up a low- or non-correlated portfolio requires detailed analysis and substantial due diligence. Ongoing monitoring is also required on each underlying fund to ensure that performance objectives continue to be met.

Access to Hidden Hedge Funds

Many hedge funds do not advertise and may not be accessible through traditional distribution channels. Information on some hedge funds is closely guarded and hard to access. Reputable managers know how to reach hedge fund managers or how to obtain information on specific funds, providing access to investors who might otherwise be shut out.

Ability to Diversify With a Small Investment

FoHFs increase access for smaller investors to hedge funds. Many Canadian hedge funds accept as little as $25,000 from accredited investors; however, some hedge funds have much higher minimum investment thresholds. An FoHF allows investors to achieve diversification with a lower investment.

Manager and Business Risk Control

Hedge funds and, to a lesser extent, liquid alts, have fewer restrictions than more mainstream investments. Thus, some believe that hedge fund management firms can terminate activities at any time for business or other reasons. This so-called blowup risk can be diversified through an FoHF, as it represents a relatively small fraction of the total assets invested. The FoHF manager’s duty is to continuously monitor and manage underlying funds to mitigate business risk.

Disadvantages of Funds Of Hedge Funds

While FoHFs have many advantages, they also have specific disadvantages and risks such as:

Additional Costs

Competent FoHF managers can be expensive to retain. Additional fees are charged for management and operating expenses, often including a base fee and an incentive fee, adding to the costs.

No Guarantee of Positive Returns

An FoHF is not a guaranteed investment and cannot be assured of meeting its investment objectives. Investors should understand that an FoHF is simply the sum of its component hedge fund investments, and returns can fluctuate negatively.

Low or No Strategy Diversification

Some FoHFs are strategy-specific and invest only in one type of hedge fund, providing less diversification than multi-strategy, multi-manager FoHFs.

Insufficient or Excessive Diversification

The number of hedge funds in an FoHF can range from five to over 100. Some may not provide adequate diversification, while others may dilute returns and over-diversify.

Additional Sources of Leverage

Some FoHFs use additional leverage to enhance return potential beyond what is used by the underlying hedge fund managers. This strategy adds costs and risks, and investors should understand and agree to it.

Key Takeaways

  • Funds of hedge funds (FoHFs) and liquid alternative funds allow significant investment in mutual funds, enhancing diversification and offering professional management.
  • Advantages include due diligence, reduced volatility, professional management, access to otherwise inaccessible hedge funds, and potential diversification with a smaller investment.
  • Disadvantages include high costs, no guarantees of positive returns, low strategy diversification in some cases, and additional leverage risks.

Frequently Asked Questions (FAQs)

What is the main benefit of investing in a Fund of Hedge Funds?

The main benefit is the diversification of risk across a variety of hedge funds and investment strategies, managed by experienced professionals.

What are the typical fees associated with Funds of Hedge Funds?

Typical fees include a base management fee (around 1%) and an incentive fee (around 10%), plus the fees charged for underlying hedge funds.

Can smaller investors participate in Funds of Hedge Funds?

Yes, FoHFs often permit smaller investments, increasing access to hedge funds which might require higher minimum investments.

Glossary

  • FoHF: Fund of Hedge Funds, a pooled investment vehicle that allocates assets among a variety of hedge funds.
  • Leverage: Use of borrowed funds to increase the potential return of an investment.
  • Due Diligence: The investigation or audit of a potential investment.
  • Alternative Mutual Funds: Funds that use non-traditional strategies like short selling, leverage, derivatives, etc., beyond classic equities or bonds.

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## What is a key characteristic of Funds of Hedge Funds (FoHF)? - [ ] Invest up to 50% of their net assets in other mutual funds - [ ] Only invest in single-strategy funds - [x] Can invest up to 100% of their net assets in other mutual funds - [ ] Only available to institutional investors > **Explanation:** Funds of Hedge Funds (FoHF) can invest up to 100% of their net assets in other mutual funds, creating a fund-of-funds structure. ## What is one of the main types of Funds of Hedge Funds (FoHF)? - [x] Single-strategy, multi-manager funds - [ ] Single-manager, multi-strategy funds - [ ] Passive index replication funds - [ ] Sector-specific equity funds > **Explanation:** One main type of FoHF is the single-strategy, multi-manager fund, which invests in several funds employing a similar strategy. ## What is an advantage of investing in a Fund of Hedge Funds (FoHF)? - [ ] No additional costs - [ ] Guaranteed positive returns - [x] Reduced volatility - [ ] Minimal diversification > **Explanation:** Investing in a FoHF can provide more consistent returns with lower volatility and risk due to diversification among different hedge funds. ## What role does the portfolio manager play in a Fund of Hedge Funds (FoHF)? - [ ] Selecting only one hedge fund to invest in - [ ] Guaranteeing positive returns - [x] Evaluating and selecting hedge funds to form a diversified portfolio - [ ] Monitoring only market conditions > **Explanation:** The portfolio manager evaluates and selects the different hedge funds to achieve a diversified portfolio and continuously monitors their performance. ## What is a disadvantage of Funds of Hedge Funds (FoHF)? - [ ] Limited access to hedge funds - [ ] Non-professional management - [x] Additional costs - [ ] Limited diversification potential > **Explanation:** One of the disadvantages of FoHFs is the additional costs incurred from management and operating expenses, on top of the fees of the underlying hedge funds. ## Which of the following is true about the investment thresholds for accessing hedge funds via FoHFs? - [x] Allows smaller investors to access hedge funds with lower minimum investments - [ ] Requires higher minimum investments than direct hedge fund investments - [ ] Only allows institutional investors to invest - [ ] Requires commitment of at least US$1 million > **Explanation:** FoHFs can lower the minimum investment threshold required to access hedge funds, allowing smaller investors to diversify their investments. ## How does the FoHF manager contribute to managing business risk? - [ ] By solely focusing on short-term gains - [x] By monitoring and managing the underlying funds continuously - [ ] By avoiding investments in all hedge funds - [ ] By investing only in high-risk funds > **Explanation:** FoHF managers continuously monitor the underlying funds to manage and mitigate business risk. ## What is a risk associated with strategy-specific FoHFs? - [ ] Excessive diversification - [x] Low or no strategy diversification - [ ] Guaranteed high returns - [ ] No need for due diligence > **Explanation:** Strategy-specific FoHFs may invest only in one type of hedge fund strategy and thus may contribute less diversification compared to multi-strategy, multi-manager FoHFs. ## What does "blowup risk" refer to in the context of hedge funds? - [ ] The inevitable collapse of all hedge funds - [ ] The expansion of fund assets due to exceptional performance - [ ] The automatic redemption of an investor’s units - [x] The risk that a hedge fund may terminate due to poor performance or other business risks > **Explanation:** "Blowup risk" refers to the possibility that a hedge fund may terminate its activities due to performance issues or other business risks. ## Why should investors understand the use of leverage in FoHFs? - [ ] Because it eliminates all risk - [ ] Because it ensures consistent positive returns - [x] Because it adds to the costs and risks of the investment - [ ] Because it is not used by any hedge funds > **Explanation:** The use of leverage can heighten both the potential returns and risks of FoHFs, so investors need to understand its implications on costs and overall risk.

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