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Home > Asset Management Best Practice > Funds of Hedge Funds versus Single-Manager Funds

Asset Management Best Practice

Funds of Hedge Funds versus Single-Manager Funds

by Steve Wallace

Advantages and Disadvantages

Below I have listed some of the main advantages and disadvantages of each option when allocating to hedge funds. Note that this is by no means an exhaustive list.

FoHFs

Advantages

  • Professionally selected underlying hedge fund managers.

  • Reduced volatility.

  • Manager diversification.

  • Ease of access.

  • Low minimum investment requirements (i.e. to invest in one FoHF the minimum investment would in most cases be less than the aggregate minimum investments of say 20 single-manager funds).

  • Ability to negotiate fees.

Disadvantages

  • Not bespoke.

  • May not fit within the overall portfolio as well as specifically selected single managers.

  • Additional layer of fees means the performance return needed to break even is higher. However, it should be noted that the investor is getting something for this extra fee level in terms of expertise at manager selection, provision of the FoHF structure, and so on. What value this translates to is dependent on the investor’s situation.

Single managers

Advantages

  • Bespoke portfolio.

  • Ability to dovetail the hedge fund allocation into the overall portfolio.

  • Transparency of the overall portfolio.

Disadvantages

  • Cost of human intellectual property required to build a professional portfolio of single managers.

  • Investment required to ensure an appropriately diversified hedge fund portfolio.

  • Overconfidence in one’s own ability, or that of one’s team, to select single managers.

  • Potential for large losses by any one manager to significantly and negatively impact your portfolio if not constructed properly.

Making It Happen

One of the points that is often made concerns a FoHF’s ability to invest in up and coming hedge funds that will generate significant returns as they grow from start-up. This comes back to ability as not all FoHFs are in a position, from the standpoint of expertise and knowledge, to invest in emerging hedge funds as this calls for a much more complicated due diligence process.

If you are a novice to hedge funds, the risk to the value of one’s portfolio by investing in such funds, whether they are single managers or a FoHF, is high. It should also be noted that if you do decide to access hedge funds via a FoHF this absolutely does not mean that you can abdicate responsibility completely. There is a whole other area of FoHF due diligence that comes into play here.

The best way to proceed is to go back to first principles—i.e. to ask yourself what was the rationale for investing in hedge funds in the first instance.

Once you have that in place, you can ask yourself the next question: What is the best way for me to access hedge fund investment opportunities? This is linked with the question whether you have the knowledge required either to invest in a FoHF or to put together a portfolio of single-manager hedge funds. If you don’t, there are a number of ways of gaining that knowledge or gaining access to it, whether it is by educating yourself by going through the Chartered Alternative Investment Analyst program, discussion with peers, use of hedge fund advisory consultants, or other means.

That will then guide you in the choice between the single-manager and FoHF paths, although, as mentioned earlier, if you have the experience to construct a portfolio utilizing single-manager hedge funds but not enough funds to gain diversification benefits, it would be foolhardy to invest in single managers.

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Further reading

Books:

  • Anson, Mark J. P. Handbook of Alternative Assets. 2nd ed. Hoboken, NJ: Wiley, 2006.
  • Ineichen, Alexander M. Asymmetric Returns: The Future of Active Asset Management. Hoboken, NJ: Wiley, 2007.
  • Jones, Chris. Hedge Funds of Funds: A Guide for Investors. Chichester, UK: Wiley, 2007.
  • Lhabitant, François-Serge. Handbook of Hedge Funds. Chichester, UK: Wiley, 2006.

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