Fund of funds

A fund of funds uses a different investment approach than traditional hedge funds. Instead of buying stocks, bonds, or other securities directly, fund of funds managers invest their capital in multiple other hedge funds. This strategy allows them to spread risk across different fund managers, investment styles, market sectors, geographic regions, and asset types. The result is typically lower volatility and better risk management compared to investing in a single hedge fund.

Fund of funds managers often use their size and industry connections to negotiate better terms with the underlying hedge funds they invest in. These special arrangements, called , provide the fund of funds with enhanced transparency and more detailed reporting than regular investors typically receive. This additional information helps managers understand their total exposure across different markets and see how their various investments might be correlated.

forms the backbone of successful fund of funds investing. Managers must thoroughly evaluate each potential underlying hedge fund to ensure it has strong operational controls and compliance systems. They also need to confirm that each fund fits appropriately with the fund of funds' investment goals, time horizon, and risk tolerance.

Tax implications significantly influence how fund of funds are structured, particularly regarding offshore versus domestic arrangements. U.S. taxpayers generally prefer fund of funds that invest in underlying hedge funds structured as partnerships, which provide more favorable tax treatment. In contrast, offshore funds typically prefer to invest in non-U.S. hedge funds that are treated as corporations for U.S. tax purposes.

These different tax preferences often lead to , where the same fund of funds strategy is offered through multiple legal entities to accommodate different types of investors.

Creating a fund of funds requires careful planning around liquidity and timing. Since fund of funds managers need to withdraw money from their underlying hedge fund investments to meet their own investors' redemption requests, they must avoid . This means the fund of funds cannot promise investors faster access to their money than the underlying hedge funds provide.

Managers solve this problem in several ways. They establish longer notice periods for withdrawals, reduce redemption frequency from quarterly to annual or semi-annual schedules, and implement redemption restrictions that match their ability to withdraw funds from the underlying investments.

Fund of funds create a significant cost issue because investors pay fees at two levels. While fund of funds typically charge lower (around 1%) and reduced (5% to 10% instead of the standard 20%), investors still pay fees to both the fund of funds and each underlying hedge fund.

To address investor concerns about these layered costs, some fund of funds managers have eliminated performance fees entirely. These managers charge only a management fee, reducing the total cost burden for their investors.

A fund of funds operates differently from a traditional investment fund because it owns shares in other investment funds rather than direct securities or loans from companies. The fund's assets consist mainly of its ownership interests in various hedge funds, plus cash and cash equivalents kept for day-to-day operations. The fund's liquidity depends on how much money it can withdraw from its underlying investments and the cash it has readily available.

When fund of funds need to borrow money through credit facilities, they use their ownership stakes in the underlying hedge funds and related bank accounts as collateral. These borrowed funds typically support either new fund acquisitions or investor redemption requests. Some fund of funds rarely use their credit facilities, while others rely on them regularly to fund new investments, manage redemptions, and optimize their operational cash flow.

The fund of funds model continues to face challenges in proving its value compared to direct hedge fund investment. The layered fee structure and the increasing availability of hedge funds to institutional investors have put pressure on the industry. As a result, many fund of funds managers have expanded beyond traditional pooled investment products to offer advisory services, managed accounts, and specialized access to hedge funds that are closed to new investors or have limited capacity.