Hedge Fund

Fund of Funds
The fund of funds is a hedge fund that invests in other hedge funds. These
portfolios offer several advantages over investment directly in hedge funds.
First, the funds of funds diversify the returns and reduce the volatility of
performance. Second, the fund of funds manager investigates the funds it
invests in and may be able to reduce the chance of losses to fraud or mis-
management. The fund of funds manager may also be able to identify
funds likely to have superior performance.
Most funds of funds are skilled marketing organizations. Not surpris-
ingly, the composition of funds of funds tends to migrate toward the popu-
lar hedge fund strategies. A small number of fund of funds managers make
forward-looking asset allocations, based on internal forecasts of profitabil-
ity of various strategies. Other fund of funds managers emphasize diversifi-
cation strongly and are less likely to overweight particular strategies.
The classic method of portfolio selection first identified by Harry
Markowitz
4
involved searching for the optimum trade-off between risk
and reward. It is fairly easy to build a model to select hedge funds to get
a portfolio with high expected returns and controlled risk. Many fund
of funds managers have models or seek to build similar portfolios in
other ways.
Unfortunately, the realities of fund of funds management and adminis-
tration prevent managers from implementing their model portfolios. Many
hedge funds impose significant lockups, preventing the fund of funds man-
ager from removing funds from one hedge fund to redeploy in another.
Even when exit is permitted, hedge funds won't redeem investments until
the next accounting break period (the monthly or quarterly intervals when
investors can enter or exit) and other funds won't accept new investments
until they reach a break period. Finally, even if a fund of funds is permitted
to exit, the manager will usually try to remain in the existing hedge funds
because it may be difficult to reenter a hedge fund after withdrawing funds
from a particular hedge fund.
As a result, the typical fund of funds manager at best implements an
approximation of the model portfolio. The manager must rebalance by re-
ducing the weight of the most successful strategy, which will be over-
weighted. If the fund of funds manager is growing, the manager may direct
money to a small number of managers and partially rebalance, rather than
making a proportionate investment in all managers. If the fund of funds is
losing investment funds, the manager will raise cash from the hedge funds
that permit withdrawals, even at the expense of distorting the balance in
the portfolio.
Hedge Fund Investment Techniques
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