Sunday, March 21, 2010

Funds of Hedge Funds

A fund of hedge finds (FoHF) is an alternative investment vehicle that invests in other alternatives, generally hedge funds. The basis rationale for this is asset allocation. A manager of a FoHF decides on the sector or types of funds that are most appealing, assigns weightings to those sectors, and looks for the best fund managers within each sector.

Critics of the fund of funds concept point out that they generate fees on top of fees and expenses on top of expenses. If you want asset allocation, you can get it without the extra layer of fees and without the extra layer of mystery about what the underlying today stock market investments are. Besides, why stop there? Why not create “funds of funds”, “funds of funds of funds of funds”. And so on ad infinitum?

Proponents respond that no single fund company can afford to hire the very best managers in all markets, whereas a fund of funds has the freedom to compile a portfolio of the best manager in the world. There are, however, at least two assumptions hiding in that argument- namely, that the fund of funds manager can identify the best managers and that the FoHF’s asset allocation will add value, not subtract it.

Other Alternatives

One of the biggest problems associated with hedge fund investing has been the lack of transparency into fund’s positions, strategies, and risks. An extreme example that came to light in late 2008 is perhaps the greatest financial fraud of all time, perpetrated by Bernie Madoff, and apparently facilitated by numerous intermediaries – wittingly an /or unwittingly. While Madoff never operated a hedge fund, billions of dollars were raised by hedge fund and fund of fund managers who offered feeder funds, funds that apparently served no purpose other than to collect fees and send the money to Bernie. The secrecy that still exists in the edge fund industry can have no grater illustration than the realization that many hedge fund managers had never even heard of Madoff or knew that a feeder fund was until he surrendered to authorities in December 2008.

The problem of lack of transparency has been tackled in two ways: by hedge fund managers offering full position-level transparency in separately managed accounts that are owned by the investors; and by financial engineers who have developed hedge fund replication strategies that are intended to offer hedge-fund-like returns and use sophisticated mathematical and computer techniques to reverse engineer hedge fund strategies, and to attempt to replicate the returns using liquid instruments, especially futures contracts. Both of these approaches are in an early stage of development, but they are garnering significant attention from investors who wish to retain the diversification benefits of alternatives without paying the price of lack of transparency, liquidity, and control.