8. Fund of Funds

• Individual investors

• Allocation < $50mm

• Considering fees and due diligence

• Strategy and manager selection

• Portfolio construction

• Risk management and monitoring

• Manager due diligence

• Portfolio Benefits

• Cost & Scale Advantages

• Institutional Edges

—> Total: 11 benefits

• Diversification

• Liquidity

• Currency hedging

• Leverage

• Economies of scale

• Negotiated fees

• Accessibility

• Information advantage

• Access to certain managers

• Regulation

• Education

• Costs & Taxes

• Governance & Information

-> Total: 6 disadvantages

• Double layer of fees

• Performance fees not netted

• Taxation

• Lack of transparency

• Lack of control

• Exposure to other LP’s cash flows

• Long-term strategic style allocation (Beta)

• Short-term tactical style allocation (Alpha)

• Individual manager selection (Alpha)

• Expertise in fund selection

• Diversification (lower capital commitments & spread costs)

• Access to LPs and liquidity management

• Proper Management Incentives

• Second layer of management fees

• Relationships with GPs remain with FoF

• Less transparency and control

• Lack of liquidity in FoF units

• Investment Objective

  • Geography, style (VC/buyout), level of diversification

• Type of FoF

  • Primary vs. secondary

• Portfolio Construction (top down; strategic weights)

• Manager and fund selection (bottom up; to build up to strategic weights)

• Monitoring

• Easy access for new, smaller PE investors

• Complement to LP funds / directs

• Operational & regulatory complexities

• PE FoFs offer diversification by reducing performance dispersion vs. single PE funds

• PE FoFs outperform public markets

• Buyout FoFs underperform individual buyout funds

• VC FoFs perform on par with individual VC funds

• Well diversified portfolio: 15-20 HFs

• Theory: S / Wurzel (N)

  • S = SD of funds

  • N = number of funds

• FoHFs underperform broad hedge fund indices

• Reasons that FoHFs may be less biased than indices

  • Inaccurate index performance (survivorship bias / history bias)

• Fund of Funds use realistic investment weights, not theoretical

• Investment strategy seeking HF exposures but offered in regulated, liquid vehicles

• Greater transparency, liquidity and investor protection

• UCITS (Europe)

• ‘40 Act (U.S.)

• Leverage

• Liquidity

• Diversification

• Reporting

• Reporting frequency: 2 weeks

• Leverage: 200%

• Strict holding and concentrations

• 35% European sovereign

• 20% investment fund

• 10% illiquid holdings

• 20% deposit at single institution

• Max position: 10% (20% with derivatives)

• Liquidity within 7 days

• Symmetric performance fees

• Min. 300% asset coverage for borrowing —> borrowing limited to 33% of assets

• Apply to 75% of the fund:

  • Max 5% in a single security

  • Max 25% in one industry

  • 15% maximum illiquid holdings

  • Max 10% ownership of any single issuer

• Macro and managed futures

• Long/short equity

• Equity market neutral

• Relative value strategies

• Combine sub-funds / sleeves

• Bypass leverage / concentration limits at fund level

• Lower risk -> slightly lower / equivalent returns to HFs

• Invest in many Hedge Funds

• Risk reduction through diversification

• Different baskets —> smoother returns

• Conservative Index

• Market Defensive Index

• Strategic Index

• Composite and Diversified Index

• Low volatility -> capital preservation

• Minimal market (beta) exposure

• Strategies: Equity neutral, Fixed Income / Convertible Arbitrage

• Hedge Market Risk

• Performs best in market downturns

• Strategies: Systematic & Short-Biased

• High Absolute Returns

• Directional Market Exposure

• Strategies: Equity hedge and Emerging Markets

• Mix of HF strategies

• Diversified Returns

• Higher return (5.6%)

• High volatility (13.9%)

• Negative skew with mild tail risk

• Moderate return (4.1%)

• Low volatility (4.1%)

• Near-normal return distribution

• Low return (3.6%)

• Moderate volatility (4.4%)

• Negative skew and tail risk

• Low return (3.6%)

• Higher volatility (6.4%)

• Negative skew with tail risk

• Low average return (3.4%)

• Low volatility (3.3%)

• Negative skew and high tail risk

• Multistrategy fund -> all gains/losses are added together

• Pay fee only when total result is positive

• Invest in newly formed HF

• Provide capital and Guidance

• VC for HF

• Invest in investment-grade, high yield, emerging market debt

• Use leverage

• Short positions