Executive Summary
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The process you undertake when selecting a FoHF is very different to that when selecting a portfolio of single managers.
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A decision on which to use, FoHF or single manager, is generally dependent on two primary factors: the monetary size of your investment allocation, and the resources at your disposal.
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The extra fee layer imposed when utilizing a FoHF structure is, in general, to pay for the resources used to source and select managers in addition to providing the investment vehicle.
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It is important to get a match between the mandate you have and that on which the FoHF is based.
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There are a number of factors that need to be considered in addition to those mentioned above when deciding whether to use a FoHF or collection of single managers; it is not a black and white decision.
Introduction
Funds of hedge funds (FoHFs) have caused heated debate over the years no matter which side of the fence you are on. The main issue this debate revolves around has two parts:
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Fees—that is, fees charged at the underlying manager level and then again at the FoHF level.
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Control: Accepting that you don’t have the internal expertise and must pass control of the underlying fund selection to a FoHF manager can be difficult for some. They would rather have control even though they may not achieve the result they hoped for rather than hand over control for a result that isn’t of their own making—regardless of the outcome.
The first step in choosing between FoHF or single manager should be to look inside the firm for the knowledge, expertise, and experience required to source and select the underlying managers. In this article I will be looking at elements of the decision to invest either in a basket of single managers or in a FoHF product.
A Definition
A FoHF, as the name implies is a fund which invests in a collection of hedge funds. The collection of funds is constructed in an effort to provide risk/return characteristics that achieve its mandate. Before I go any further it should be noted that a FoHF does not only apply to hedge funds; it is a portfolio construction process that is also utilized by long-only products, i.e. FoFs (funds of funds).
The basic premise of a FoHF is that a portfolio can be constructed in such a way as to generate a rate of return with lower volatility than may otherwise be the case if the investor constructed the portfolio himself, dependent of course on the investor (as I will discuss in the next section). As such, the FoHF manager is saying that it has the ability to source, research, and select funds which, when brought together to form a portfolio, can satisfy the investor’s investment mandate while reducing volatility.
Probably the two most often mentioned risks that a FoHF aims to reduce are manager risk and downside risk, which are in any event inextricably linked. Manager risk is reduced by the simple fact that more than one is involved in the product, thereby reducing the risk to that element of your portfolio which a single manager could bring. In other words, purely by having more managers in your portfolio you reduce the risk to your portfolio of any one of them failing, whether this be operationally, performance-wise, or in terms of strategy. The other primary risk that FoHFs aim to reduce is downside risk; arguably, one of the main benefits of a FoHF is not that it will “shoot the lights out” in terms of performance but that it will manage the downside risk.
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