With the pain of the financial crisis still fresh among equity investors, the quest for uncorrelated asset classes remains strong. These alternative investments, considered safe havens by risk-averse investors, include commodities, real estate, frontier market securities, smart beta ETFs, and hedge funds.
The inclusion of these segments diversifies an investment portfolio, reducing market risk. Some investors take this a step further-investing in the ultimate diversifier, a fund of funds.
What is a fund of funds?
As the name implies, a fund of funds (FoF) is an investment vehicle that invests in other funds, not individual securities directly.
There are funds of hedge funds, funds of private equity funds and even funds of venture capital funds for those investors who want to spread the risk of speculative, early-stage projects.
The fund pools capital from a variety of investors and typically allocates the money to various funds with differing strategies. These strategies help buffer the returns of traditional, ‘long-only’ stock market holdings. It may also be a ‘multi-manager’ strategy if component funds are run by different managers, further dissipating risk.
Fund of funds investors are both institutional and individual. They are an attractive option for many university endowments, pension funds and family offices. They are also used by high net worth individuals who want exposure to such strategies and manager diversity.
The fund of funds area now accounts for roughly $441 billion in assets under management.1
A hedge fund of funds manager has access to funds with the following strategies:
- Market Neutral
- Quantitative (‘black box’ strategies)
- Relative Value
- Merger Arbitrage
- Event Driven
A private equity fund of funds might include these strategies:
- Real Estate
- Leveraged Buyout (LBO)
- Venture Capital
- Mezzanine financing
- Distressed Debt (‘vulture capital’)
How Does a Fund of Funds Work?
Here is an example of how funds of funds can smooth out return. Assume you’ve recently taken over the investing responsibilities for a small college endowment fund. Since their asset allocation traditionally has a heavy weighting of equities (individual stocks, mutual funds and exchange traded funds), the fund was hammered during past market sell-offs.
It has finally clawed back to its prior level.
Looking forward, you are looking to smooth out the fund’s return profile, so you consider allocating capital to hedge funds. But you aren’t sure how to separate the good managers from the bad or what strategies to even consider. You decide to outsource those responsibilities and invest with a hedge fund of funds.
The FoF manager places a portion of the endowment into four different funds with different strategies and managers. The endowment soon has investments in a quantitative fund, a long/short fund, an arbitrage fund and a turnaround fund.
Since these strategies are uncorrelated to equity markets, they should produce positive returns regardless of the broader markets and reduce the endowment’s risk. You agree to pay a 1.5% management fee to the FoF manager and a 10% incentive fee. You realize this is a bit steep but the college’s trustees are focused on reducing fund volatility.
The Case for Fund of Funds
Fund of funds offer investors tremendous diversification benefits. Most investors are only ‘diversified’ by owning different types of equities-a few ETFs, a mutual fund or two and maybe a couple stocks or ADRs. But this ‘variety’ of equities is hardly protection in a severe bear market, where correlations tend to converge to one and liquidity becomes the main catalyst for the selling. By incorporating different strategies, market risk can be reduced and portfolio volatility is dampened.
The diversification goes beyond asset class and addresses manager risk as well.
For every successful hedge fund like Bridgewater Associates, there is a ‘Long-Term Capital’, the fund comprised of Nobel Prize winners that blew up in the late 1990s, that almost took down our financial system.
By diversifying across managers, the risk of losing all the investment to a rogue trader is reduced. To increase safety, a good FoF manager performs serious due diligence on the managers.
Fund of funds somewhat democratize investing. Through the use of so-called ‘feeder funds’, investors that wouldn’t normally qualify as hedge fund investors can participant.
It also provides access to some individual funds that are ‘closed’ to new investors. Normally, only ‘accredited investors’ can participate in such private investments. Accredited investors have a liquid net worth of at least one million dollars and/or an income of $200,000 over the last year.
The Case Against Fund of Funds
The main criticism of fund of funds are the high fees which eat into investor returns. The standard charge for hedge funds is the classic ‘2 and 20’, 2% management fee related to assets under management and a 20% performance fee (assuming the fund is above its high water mark).
Additionally, fund of fund managers typically charge a 1.5% management fee and a median 10% incentive fee (yes, on top of the individual hedge fund fees).2
These fees can result in serious performance drag over time. It’s hard enough for actively managed mutual funds to match passive index funds in terms of performance, so paying higher fees on top has caused a number of asset managers (such as CalPERS) to reduce hedge fund allocations.
In addition, the component funds may also hold significant cash balances as they wait for opportunities to arise. The management fee is still charged on cash balances so investors are essentially being charged to hold cash.
Many hedge funds have a ‘gate’ or lock up period, during which investor funds cannot be redeemed.
By indirectly allowing access by retail investors with shorter time horizons, this illiquidity could pose a problem. Additionally, fund managers can ‘side pocket’, or freeze investor capital if there is an extraordinary condition where withdrawals could severely harm the fund’s value.
This tactic was famously executed by Scion Capital’s Michael Burry, profiled in Michael Lewis’s The Big Short. Scion’s institutional investors were furious and threatened to sue.
The illiquidity may be even worse for private equity funds, whose holding periods are often measured in years because of investments such as commercial real estate projects.
Clarityspring reveals another potential drawback, position netting, which is something investors need to be aware of.3 They point out that investors may be paying fees on neutral positions.
Let’s say you have invested in a fund of funds holding a technology growth fund and a long/short fund. The growth fund may have a substantial position in a hot new tech stock while the long short fund may have deemed the stock irrationally exuberant and shorted it. Both funds are charging a fee for essentially no exposure to the stock.
Blackstone, UBS and Goldman Sachs, and HSBC Alternative Assets top the list of largest hedge fund of funds according to Institutional Investor’s Alpha.4
At over $67 billion, Blackstone’s Alternative Asset Management is nearly twice the size of the next largest fund of funds, UBS Hedge Fund Solutions.5 For private equity fund of funds, the largest names include HarbourVest, Adams Street and Pantheon Ventures.
Working at a Fund of Fund
Fund of fund managers do extremely well. The services provided by fund of funds managers have less to do with actually running the investments for a particular strategy-rather it is more about manager selection and due diligence. In other words, it’s about their connections.
An interview with a PE fund of funds analyst on the website Mergers and Inquisitions revealed that pay is somewhere between investment banking and private equity-the salary for a Fund of fund analysts may be between $70k-$100 plus about the same for bonus.6 That averages out to somewhere around $170,000 in total annual compensation.
What you can’t put a price on is the value of the contacts you will make. Hedge fund and PE professionals will want to network with you, because you can provide them with capital to manage their funds.5 This is certainly true of newer funds looking for capital to become viable.
Working at a fund of funds is an often overlooked financial career option. But it can be very rewarding, assuming you have access to smart fund managers for your clients. Good luck!