Hedge funds and funds of funds are both investment vehicles used to diversify portfolios. However, investors choose the type of fund based on their preferences. Investing in these types of funds comes with unique upsides and downsides. But, what should investors look at when thinking about hedge fund vs fund of funds investments?
Hedge funds directly invest in different asset types like bonds, stocks, and currency. On the other hand, fund of funds (FoFs) invests in various types of fund vehicles. Hedge funds are loosely regulated when compared to the strict disclosure requirements of FoFs. Also, a major difference is in fee structure. Hedge funds can charge significantly more than FoFs.
Since they are using different investment approaches, that draws several distinctions. Knowing what type of fund strategy you should opt for demands a thorough analysis. Stay with us while we dive deeper into the topic of these similar but still diverse types of funds.
What is a Hedge Fund?
The hedge fund is an investment vehicle that pools capital from the investors. These funds are usually organized as limited liability companies (LLCs) or limited partnerships (LPs). That way partners in the fund are protected in case of an investment loss.
Hedge fund managers use the money to invest in various asset classes. They can invest in liquid or illiquid assets. Their investment approach aims to diversify the investment portfolios of their clients. From their clients, they request to be accredited investors. The primary reason for this is often risky investment strategies that hedge funds employ to maximize returns.
To manage risk hedge funds use sophisticated and diverse risk-mitigating strategies. Hedge funds have a bad reputation. This is due to their lack of transparency and lenient approach to regulations.
What Do You Mean By Fund of Funds?
Fund of Funds is an investment vehicle that focuses their investment in other types of funds. They usually invest in pension funds, ETFs, mutual funds, and hedge funds. They do not directly invest in individual assets.
Their investment portfolio is composed of different underlying portfolios of other funds. They are typically classified as fettered or unfettered investment vehicles. Fettered FoFs are only able to invest in funds managed by the FOFs managing company. Unfettered can invest in funds across the market.
Investment Strategy
Hedge Funds
Hedge funds utilize a wide array of investment strategies. The primary aim is to diversify the investment portfolio. These strategies can be widely grouped into several types based on their own set of techniques, risk profiles, and objectives. When talking about types of hedge funds, they are determined by the strategies they use. These are common hedge fund strategies:
- Long/short equity. The approach of this strategy is to take both long and short positions in stocks. Long-positioned stocks are assumed they rise in value over time. These positions are kept until they generate enough returns. Short-positioned stocks have the prerequisites to go down. Hedge funds borrow these bonds and immediately sell them. Then the price goes down. Managers buy shares at a lower value and return them to the lender
- Global macro. Funds that use this strategy take positions based on macroeconomic trends and events at a global level. These can include the direction of interest rates, currency exchange rates, and other macroeconomic factors. Hedge funds are managing their exposure to this market with the use of complex instruments like derivatives. This strategy aims to capitalize on economic and geopolitical trends while betting on different asset types
- Event-driven. This approach consists of identifying possible investment opportunities based on specific corporate events. The events in question can be mergers, acquisitions, bankruptcies, or restructurings. Managers of hedge funds research potential targets. They are looking for potential price movements resulting from these events
- Arbitrage. The goal is to capitalize on price differentials between related securities or markets. There are three main types of arbitrage. Merger arbitrage exploits price discrepancies in the shares of companies involved in a merger or acquisition. Convertible arbitrage capitalizes on the difference between a company’s stock and its convertible securities. Statistical arbitrage utilizes quantitative models to identify short-term mispricings in securities
- Distressed investing. This risky approach focuses on investing in companies that are in financial distress. Hedge funds often buy the debt of distressed companies and restructure it. Another approach involves taking control of the company and changing it from within. Then, with the increase of the value, the potential return of the trade increases
- Quantitative strategies. Funds that focus on using a quantitative approach utilize mathematical models and algorithms to make investment decisions. With the help of these models, managers analyze historical data, market trends, and statistical patterns. The manager’s goal is to exploit quantitative patterns in financial markets
- Algorithmic trading. This type of trading is executed automatically by a computer program. To use this strategy, managers need to have an extensive knowledge of programming and mathematical skills. These programs can implement a variety of trading strategies. Some of the favorites are high-frequency trading and arbitrage
- Long-only equity. Some hedge funds focus on the traditional approach to investing that focuses on long-only equity. This strategy is also frequently used by mutual funds. However, hedge funds can use this strategy with arbitrage or derivatives to achieve some flexibility
- Market neutral. The market-neutral approach is based on taking both long and short positions on the stocks that are expected to gain and lose value. Hedge funds use this strategy to neutralize the risk of the market. Also, they are looking to profit from the relative performance of the two stocks.
Funds of Funds
The primary focuses of FoF managers are diversification and asset allocation. Fund of Funds differentiate their portfolio by investing in various underlying funds. By doing so they are spreading out the risk across different asset classes and investment approaches. This way the impact of a single-market downturn is minimized.
FoFs invest in various types of funds, depending on their goals. They often buy portfolios of mutual funds, exchange-traded funds (ETFs), private equity funds, and hedge funds. This approach not only reduces risk, but also broadens the exposure to various sectors, and geographic regions. With this detailed diversification, FoFs can help to reduce overall portfolio volatility. It also aims to improve long-term returns.
When defining asset allocation, FoF managers choose investment targets. They are based on the fund’s specific objectives and risk tolerance. They check the portfolio of the fund and compare the FoF goals with theirs. Managers determine the optimal amount to invest in stocks, bonds, commodities, real estate, and other asset classes.
Depending on the goals and risks, the investments can be static or dynamic. If they are static they will remain the same over time. Dynamic investments are adjusted over time, based on the changes in the market, and the fund’s performance.
Take A Look At Fund of Funds – Private Equity:
Allocating assets is crucial for every FoF operation. Effective asset allocation helps to balance risk and return. It also ensures that the portfolio aligns with the investor’s financial goals.
Additionally, FoFs employ tactical asset allocation. This involves actively adjusting the asset allocation based on short-term market movements. This approach helps capitalize on opportunities or mitigate risks.
They can also base their investment strategy on investing in funds managed by different asset firms. When they choose this approach FoFs aim to benefit from diverse expertise and investment styles.
FoFs also commonly use overlay strategies. These strategies involve using derivative instruments to further hedge portfolio risk or enhance returns.
Investment Selection
The FOF managers conduct thorough research of the funds before investing. Their primary focuses are on the fund’s performance history, investment strategy, fees, management team, and risk profile. The goal is to select funds that are aligned with the FoF strategy.
Also, managers always prefer funds with a constant and good performance history. Another important characteristic is a clear regulatory history. It should not have any transparency or disclosure stains in the past.
For even further diversification and risk mitigation, managers may consider the correlation between different funds. As a part of long-term research, managers are conducting ongoing monitoring and analysis. This way they are ensuring that the funds continue to meet the desired criteria and adjust the portfolio as needed.
Risk Assessment and Management
Hedge Funds
Risk assessment and management are crucial elements of hedge fund operations. Since hedge funds use a variety of investment strategies effective risk management is the key to protecting the investor’s interests. It also ensures the long-term success of the fund. Hedge funds are exposed to several risk types. To counter them, they are utilizing complex strategies.
Key Risks
- Market risk. Hedge funds often aim to generate profit from market discrepancies. That also works in the other way, causing market risk. Common market risks include equity price movements, interest rate fluctuations, currency exchange rate changes, and global economic events. If these risks are not properly managed they can lead to major losses
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Liquidity risk. Depending on the hedge funds approach they can invest in considerable ratio to illiquid assets. This can result in problems with selling the assets. This is particularly a case in times of high market volatility
- Operational risk. Day-to-day operations at the hedge funds are susceptible to operational risk. The problems can be caused by fraud, theft, or errors in conducting sales. These issues can result in serious reputational damage and losses
- Counterparty risk. Hedge funds heavily rely on other financial institutions to execute their trades and fulfill their contractual obligations. If the counterparty defaults that can lead to significant losses for the hedge fund
- Manager risk. How the hedge fund will perform is heavily dependent on the managers. Their level of skill, knowledge, and experience is crucial. Poor investment decisions or unethical behavior can lead to significant financial losses and reputational damage
- Investment strategy risk. Choice of strategies can also cause a risk for the investor. Some hedge funds prefer to use more risky strategies like leverage and short-selling. If they are not properly executed they can result in big losses.
Hedge funds use different approaches to measure and assess the risk of their investments. With quantitative models, they analyze historical data and identify potential risks. Based on those they forecast future market movements. These models can help in identifying potential risks and opportunities.
They conduct stress testing to create a simulation of various market scenarios. These tests can show the potential impact on investment in specific situations. Common scenarios include economic downturns and interest rate spikes.
With a risk approach budgeting hedge funds set clear risk limits for different asset classes and investment strategies.
Risk Management Strategies
- Portfolio diversification. The primary risk management strategy is portfolio diversification. When hedge funds invest in different asset classes and geographical regions, using different strategies, they mitigate the impact of any single risk factor.
- Position sizing. By limiting the size of a specific position portfolio managers aim to minimize the loss of a single investment
- Stop-loss orders. Managers use stop-loss orders when they apply automated trading orders to sell securities at a specific price. This strategy minimizes the chance for major losses in particular investments
- Hedging strategy. Hedging encompasses using derivative instruments like options or futures contracts. Those hedge funds offset the risk of sudden price movements in other investments
- Risk management team. Hedge funds for risk management teams to oversight and ensure alignment with risk management policies
- Continuous monitoring and reviewing. This essential practice includes checking the performance of all investments and their risk profiles. If needed positions and strategies are revised
- Transparency and communication with the investors. Hedge funds should aim to have regular and transparent risk management discussions with the investors. That way the trust in the fund increases, and funds can adjust their investments to investor’s expectations.
Funds of Funds
Fund of funds conducts similar approaches to risk assessment and management as their hedge fund counterparts. They conduct thorough research and analysis of underlying funds. FoFs use qualitative analysis to evaluate the qualitative factors of the underlying funds.
FoFs check their compliance with regulations and reputation in the industry. They are also inspecting whether are they following ethical and responsible investment practices.
They also use scenario analysis like hedge funds. However, they focus on the potential impact the risks associated with the underlying funds can have on FoFs performance. With scenario analysis, they also conduct stress testing to check the FoFs portfolio. They also check how it handles extreme market conditions. Stress testing helps in identifying potential vulnerabilities. This can also help in assessing risk management practices.
Like hedge funds, FoFs also pursue diversification of the investment. Just in this case, the aim is to diversify along potentially viable underlying funds. FoFs are conducting portfolio weighting, by allocating investments along underlying funds. The choice of funds is made on their risk profiles and potential returns.
When FoFs want to limit their exposure to any single risk factor they set clear risk limits for different asset classes. Managers are also conducting regular checkups of the portfolio in search of any deviations from risk limits or investment objectives.
A good approach to risk management in all investment funds is based on two factors. The first is to, establish risk management teams. The second is keeping the communication with the investors open. That way there are always responsible managers managing the risks. Also, the fund has all the relevant information coming from the investors.
Returns and Performance
Hedge Funds
Hedge funds are known for their chance to generate high returns. This is due to their approach to generating alpha. This means that they are focused on generating positive returns no matter the current market conditions. But, the chance to generate returns can vary, depending on several factors.
The factors that have a major impact on the fund’s returns are strategies that the fund uses, market conditions, and manager skills.
A wide array of strategies come with different levels of risk. Some can end with high returns, but also a high chance of complete loss. Other strategies do not guarantee large returns, but they are more constant and secure. Long/short strategy can offer significant returns but with a higher volatility. On the other hand, arbitrage strategies come with medium returns, but also lower volatility.
The market condition can have a major impact on returns, and hedge fund performance. Sudden economic downturns, major geopolitical events, or changes in interest rates can put a dent in returns. Sometimes, even the best-managed funds cannot nullify the negative aspects of these situations.
It is known that hedge funds employ only the best managers and analysts. However, this is not always the case. A manager who cannot identify and exploit market opportunities will have a solid impact on the fund’s performance. Only proven and experienced managers can bring the expected returns.
On the downside for every investor are hedge fund fees. Hedge funds have a two-component fee structure including a performance and a manager fee. Those fees can take a solid chunk of any return.
Funds of Funds
Unlike hedge funds, FOFs do not directly invest in liquid and illiquid assets. They offer a wide diversification through investing in a portfolio of underlying funds. Through those investments, investors have an opportunity to gain access to different assets and strategies. On the plus side, they can achieve it through a single investment.
However, how much return can an investor expect from their investments is derived from several factors. The primary factor is the performance of the underlying fund. When the FoFs are choosing the fund to invest in, they should identify those with stable positive performance.
Another factor that plays a big role is the investment strategy. Some FoFs focus on investing in funds that utilize specific asset classes or regions. Those classes or regions carry specific characteristics, including returns.
Like with hedge funds, FoFs are under significant impact from marketing trends. Sometimes even if the fund does everything properly, it may perform poorly due to sudden market shifts. This can result in low or negative returns that were not expected.
Fees and Costs
Hedge Funds
Hedge funds utilize an often criticized compensation approach. They charge a two-component fee. It is made of management and performance fees, and it is frequently addressed by “2 and 20”. The management fee is based on the amount of assets under management (AUM), and it is usually 2%. The performance fee is charged when an investment overperforms an earlier benchmark, and it is set to 20%.
These fees recently became an important topic. Due to higher competition in the investment vehicle market, some funds have lowered their fees.
Additional charges can include sales charges, administrative and operative expenses, and redemption fees. Depending on the fund they can charge the investor when they sell or buy shares. Redemption fees can include fees in case the investor demands redemption within a certain period. Part of the performance fee can be used to pay for other services like fund administration.
Funds of Funds
Fund of funds also charge a two-component fee. But, unlike hedge funds, their fees are lower. The management fee is in the range of 0.5$ to 1.5%. The performance fee is also lower, and it can vary between 10% and 20%.
Liquidity
Hedge Funds
Hedge funds often practice long lockup periods and rare redemption chances. Usually, when an investor invests in a hedge fund, he is subjected to a lockup period that can last for several years. The lockup period primarily depends on the strategies hedge funds use.
Investors also cannot frequently redeem their investments. Depending on the fund it can be done quarterly or annually. If the hedge funds invest in more illiquid assets, that can result in investors having to wait for their returns.
Another impact on the liquidity is the size of the fund. Smaller funds have smaller amounts of assets under management. That is directly connected with their possibility to redeem their investors.
Depending on the fund, they may impose so-called gate provisions. These restrict redemptions during periods of market stress. The other cause for setting gate provisions is waiting for specific liquidity constraints to wane.
Funds of Funds
Liquidity management plays a crucial role in the success of fund of funds. Often complex operations of FoFs require careful liquidity planning and implementation of appropriate practices.
When conducting business with investors, FoFs need to clearly define investor redemption rights in their offering documents. These documents need to address several issues. Those include redemption notice periods, redemption gates, and mechanisms for combating price swings.
When planning a redemption strategy, FoFs managers need to align redemption terms with the underlying fund’s liquidity profile. By doing so the FoFs are aiming to avoid forced asset sales and maintain portfolio stability.
Before the FoF invests in the underlying fund managers need to carefully examine their liquidity profile. Factors that impact the liquidity profile are asset type, market depth, and redemption terms.
Fund of funds can implement different liquidity management tools. With those, they can manage investor redemptions and maintain fund liquidity. With the use of notice periods, investors are required to announce their redemption intention earlier.
The FoFs can use the redemption gate to suspend redemption temporarily. When using the redemption gate, they can set a certain threshold that will limit further redemptions. Also, FoFs can pass on transaction fees of redemptions to the investors. Another safety approach is utilizing liquidity lines. FoFs can access credit lines with banks to gain access to capital needed for unexpected redemptions.
FoFs can test future investments for potential liquidity problems during stress tests and scenario planning. These tests and plans can help anticipate problems before they happen. Then managers can plan risk mitigating strategies that will minimize the impact on liquidity.
FoF managers are encouraged to maintain open and direct communication with the investors. That way the managers will know what liquidity policies the investors would prefer. Depending on those, they can plan their future investments. Through regular communication with the investors and regular reports on liquidity metrics, the managers are building investor’s confidence.
Of course, when talking about liquidity the first thing that FoFs must uphold are regulatory requirements. These standards are strict. They set a boundary for implementing liquidity management practices. FoFs with the help of technology can improve liquidity management processes. These technologies also offer the possibility to monitor and provide real-time insights into portfolio liquidity.
Regulation and Compliance
Hedge Funds
Hedge funds due to the sophisticated nature of their strategies and the potential risks operate in a complex regulatory environment. They pose a potential risk to both investors and the broader financial system and thus are under complex regulation.
Three groups of regulations are applied to hedge funds and are based on their jurisdiction. There are the United States, the European Union, and global regulations.
United States Regulations
In the past hedge funds were exempt from detailed regulatory scrutiny. However, in recent years, due to the global impact of hedge funds, they have been put under a much stricter regulatory overview. These are the key regulations that are applied in the United States:
- Investment Company Act of 1940. According to this act, most hedge funds are exempt from registering as investment companies. A threshold for registering as an investment company is 100 investors. Hedge funds that have more investors have to register. This act also defines the term accredited investor concerning hedge fund investing practices
- Securities Act of 1933. This act regulates the registration and sale of securities. This is also applied to hedge fund interests. Hedge funds may need to file registration statements or exemptions depending on the offering structure. But, according to Regulation D hedge funds often rely on exemptions from the registration requirements of the Securities Act. To qualify for certain exemptions hedge funds usually limit their offerings to accredited investors
- Securities Exchange Act of 1934. This act regulates hedge fund registration with the SEC and complying with the reporting and recordkeeping requirements. With this act, it is also prohibited insider trading, and it also contains anti-fraud provisions
- Investment Advisers Act of 1940. This is a U.S. federal law that regulates investment advisers. Hedge funds are not directly subjected to this act. However, investment advisors who work in hedge funds are under strict regulation from this act. Most hedge fund managers fall into this category unless they qualify for an exemption
- Commodity Futures Trading Commission (CFTC) Regulations. Hedge funds that practice trading futures and options must register with the CFTC and follow their regulations.
European Union Regulations
- Alternative Investment Fund Managers Directive (AIFMD). This directive regulates the management and marketing of hedge funds operating in the EU. It sets boundaries for hedge fund managers. They are regarding risk management, transparency, and investor reporting
- Markets in Financial Instruments Directive II (MiFID II). This directive enforces best trade execution and pre-trade transparency practices.
Global Regulations
- International Organization of Securities Commissions (IOSCO). This organization sets global standards for security regulations. It has a guide on hedge fund risk management and supervision
- Financial Stability Board (FSB). This board monitors risks associated with hedge funds and promotes overall global financial stability.
Funds of Funds
Due to their complex and layered structure, funds of funds face strict regulatory scrutiny they must uphold. They share similar levels of regulation to hedge funds and are divided across jurisdictions.
Regarding the United States, FoFs have to comply with the acts that we already mentioned regarding hedge funds:
- Investment Company Act of 1940.
- Securities Act of 1933.
- Securities Exchange Act of 1934.
- Advisers Act of 1940.
They fall under the same regulatory scrutiny in the European Union and the global jurisdiction.
The main difference is that Fund of funds depending on the case have to comply with regulations applied to the funds they invest in.
Suitability for Investors
Hedge Funds
Hedge funds use complex and various techniques and that defines them as advanced investment vehicles. Investors who decide to invest in hedge funds should have some previous investment experience. Possessing a financial educational background can also come in handy. This may sound like an overstatement, but there are several considerations to think about before investing in hedge funds.
Before investing, investors should define their financial goals. Those include investment return horizon and risk tolerance. Then when choosing a hedge fund, their investment approaches should be closely aligned with the investors.
When considering risks there are two factors. What strategies do hedge funds employ to generate returns? How risky are they? And, how are managers handling investment risk? Investors should practice due diligence, and investigate these crucial factors.
Even if the investors do not have a deep understanding of hedge fund strategies and approaches, they can invest in them. In that case, it is recommended that the investors consult with the financial advisor. When searching for the advisor look for those with a clean record and total objectivity.
One of the key aspects that investors should align with is liquidity. Most hedge funds have limited liquidity. This means that their access to funds will be restricted. If the investor has a long-term investment horizon then a hedge fund is a good choice.
The first threshold that the investor has to overcome is gaining accredited investor status. If the investor cannot fulfill one or both conditions, then the rest of the considerations are irrelevant. If the investor is looking for another approach to enter the investment arena, choosing mutual funds, or ETFs is a better choice.
Funds of Funds
Although investing in FoFs is something different than investing in hedge funds, it brings its share of risks.
Fund of funds invest in underlying funds. That opens risks closely connected with a lack of transparency. It is difficult to assess all the funds that the FoF is choosing to invest in. They have their investment approaches and goals. Practicing due diligence with FoFs is on another level.
Since Fund of Funds uses complex approaches to identify and invest, it is an upside to have some investment sector experience. The sheer variety of funds they can invest in demands solid financial knowledge.
Depending on the type of FoF they may have different minimum investment requirements. However, FuFs are considered to be an investment vehicle for wealthy individuals and institutions. That is understandable because investing small amounts of capital into a wide array of funds doesn’t have much financial logic.
Like hedge funds, funds of funds also have limited liquidity. This is due to the highly diversified investment approach. The fund has to have enough liquid assets so they can make adjustments in case of sudden changes.
FAQs
Is a Fund of Funds a Hedge Fund?
No, the fund of funds is not a hedge fund, although they share a certain amount of similarities. FoFs investment approach significantly differs from hedge funds. They do not invest in securities but in underlying funds.
Fund of funds offer slightly lesser risk, due to their high investment diversification. They also offer slightly better liquidity than hedge funds. Another upturn from hedge funds is lower fees for their services.
When choosing to invest in FoF investors can also invest in hedge funds if the FoF managers have that approach. Also, some hedge funds may operate similarly to FoFs. They achieve this by investing in underlying assets, including other hedge funds.
What Is an Example of A Fund of Fund?
There are several types of FoFs and we will go through them and mention prime examples.
- Target date funds. They are automatically adjusting their asset allocation, with time becoming more conservative. This is connected with the investors reaching their prime retirement age. Some examples of these funds are the Vanguard Target Retirement 2055 Fund (VFFVX), and Fidelity Freedom Index 2060 Fund (FFSIX)
- Asset allocation funds. These funds focus on specific asset allocation, such as 60% stocks and 40% bonds. Some of the best examples of these funds are the Schwab Balanced Fund (SWOBX), and T. Rowe Price Global Allocation Fund (PRAGX)
- Fund of hedge funds. Their prime approach is investing in a wide array of underlying funds to gain diversification and potentially high returns. Noticeable examples of these funds include Blackstone Alternative Multi-Manager Fund (BXMX), and AQR Diversified Alternatives Fund (AQDAX).
- Index FoFs. These funds primarily follow the performance of a specific index, such as the S&P 500 or the MSCI World Index. Invesco S&P 500 Equal Weight ETF (RSP), and Vanguard FTSE Developed Markets ETF (VEA) are some examples of these funds.
Final Considerations
Investing is one of the favorite options for gaining capital. Different approaches offer different results. The potential investor should check its goals, and compare them with the investment vehicle goals. Hedge funds and FoFs offer wide diversification of the portfolio. But, they do not share the same approach.
Their risk management and investment strategies are different. FoFs are slightly less risky but bring modest returns. Choosing the right approach is based only on your needs. We went into detail about these funds, but if you are still not sure, it is best to talk with an advisor. For additional articles about investment advice, check out our blog!
