Advantages of a Fund of Hedge Funds

In a post earlier this month, I referred to a survey by the InvestHedge Billion Dollar FOHF Club which stated that there were inflows in the latter half of 2010 for funds of hedge funds.  The main disadvantage of funds of funds versus a hedge fund is the additional layer of management and incentive fees.  Average fees are 1% - 2% of assets under management, 0.5% for custodians and other services and performance fees of 20%.  The hurdle rate when the incentive fees are activated is around 10%.  The fund of funds managers are sometimes able to reduce the fees paid out to their investment managers because they have a large amount of liquid capital.

Here are the main advantages for fund of funds:

• Risk management - Diversification by investment strategy and the portfolios of the hedge funds
• Transparency and regulation - Better reporting on portfolio holdings, commentary from fund managers and documentation
• Minimum investment is lower - Allow access to multiple hedge funds at a lower capital level
• Access to closed funds - Hedge fund managers may allow fund of funds to invest in their closed funds because the fund of funds is a long term investor, has a good relationship with the manager or is a current investor.
• Liquidity - Monthly
• Portfolio management and monitoring - fund of funds manager invests in different funds, does due diligence and monitors funds for performance, risk and strategy

The source for this article is a Fund of Hedge Funds: An Introduction to Multi-manager Fund by Martin Fothergill and Carolyn Coke of Deutsche Bank.