A fund of hedge funds (or "fund of funds") is a pooled investment fund that invests in other hedge funds in order to provide investors access to many different fund managers and their investment strategies, while generally spreading the risks over a variety of funds. The blending of different strategies and asset classes aims to deliver a more consistent return than any of the individual funds, while minimizing risk and volatility.

Individual (or "single manager") hedge funds and funds of funds both accept money from individual investors and institutions to invest on their behalf. Fund of funds managers invest in other hedge funds rather than trade directly in the financial markets. Hedge fund managers, on the other hand, develop and implement sophisticated trading and investment strategies to achieve their investment objectives. They are active, direct traders in the financial markets. By contrast, managers of funds of funds construct portfolios of underlying hedge funds in order to achieve specific investment goals. In other words, fund of funds managers perform the due diligence, construction, and monitoring functions that an investor would otherwise have to carry out in constructing and managing a portfolio of investments in hedge funds.

Creating, monitoring, and managing a diversified portfolio of hedge funds is complex and costly. The initial process of gathering information on hedge funds and managers in order to construct portfolios is expensive and time consuming. This due diligence and analysis must be continuous, since the process of manager selection, portfolio construction, risk monitoring and portfolio rebalancing is neverending. Many individual investors lack the skills and resources required to assemble and monitor a successful portfolio of hedge funds. Funds of hedge funds make this process more efficient and cost-effective for investors by providing the necessary management skills and spreading costs among a larger number of investors.

Efficient Diversification

Managers of funds of funds seek to deliver efficient diversification through their skills in manager selection, portfolio construction and continuous risk monitoring. An investor can achieve broader exposure to different hedge fund managers and strategies with a comparatively small amount of time and resources by investing through a fund of funds rather than directly in individual hedge funds. For example, to ensure adequate diversification, an investor directly investing in hedge funds would typically identify and hire a minimum of 10 to 20 managers. This is a time-consuming and costly process that requires substantial resources. As a result, many investors have opted instead to invest through funds of funds.

Manager Selection

Finding, evaluating and selecting investment-worthy hedge fund managers is a complex process. Investors generally find it more difficult to gather information about hedge funds and hedge fund managers than about the public equity markets. Accurate and complete information, however, is critical in locating and evaluating worthwhile hedge fund managers. An investor must have skills, knowledge and experience with respect to the hedge fund industry; good relationships with industry professionals; and patience and persistence to gather and evaluate all the relevant facts necessary to hire the best managers. Funds of funds employ persons with the skills and knowledge necessary to make these evaluations and decisions.

Portfolio Construction

A manager of a fund of hedge funds assembles its portfolio through a continual application of asset allocation and portfolio construction techniques, with the goal of optimizing performance while reducing risk-not by randomly selecting a variety of hedge fund strategies. Finding the right blend of exposures requires a combination of quantitative analytics, experience and good judgment. The fund of funds manager aims to construct a portfolio that will deliver more stable returns under most market conditions through access to a variety of strategically selected hedge funds.

Monitoring

Selecting managers and building a hedge fund portfolio are the beginning of an ongoing process. To monitor a portfolio of hedge funds effectively, an investor must continuously perform due diligence on the funds in the portfolio and evaluate each fund individually and alongside the other funds in the portfolio. A manager of a fund of funds has the substantial financial and intellectual capital needed to perform this function, and can do so more efficiently and skillfully than many investors who lack similar resources.

Access

Funds of funds often provide investors better access to hedge funds than investors would be able to obtain directly. The minimum investments required by hedge funds, often $1 million or more, can make it difficult even for some institutional investors to diversify their hedge fund exposure adequately. For example, a foundation with a $100 million endowment seeking to invest five percent of its portfolio, or $5 million, in hedge funds may have difficulty spreading its exposure to more than five hedge funds if it invested directly. However, it may be able to achieve much wider diversification if the $5 million allocation were invested through one or more funds of funds.

In addition, as the demand for hedge funds grows, an increasing percentage of the best hedge funds are closing to new investors, while continuing to accept capital from existing investors. Many funds of funds already have large positions with these hedge fund managers. As such, investing through a fund of funds may enable an investor to gain access to otherwise "closed" managers.

The services that funds of funds provide to investors in performing due diligence, constructing portfolios and monitoring performance are not without cost. Managers of funds of funds charge a fee for their services that is typically composed of both a flat management fee based on assets, often one percent, plus an incentive fee based on performance above some threshold "hurdle" rate. The fees charged by managers of funds of funds are in addition to the fees charged by managers of the underlying hedge funds that make-up its portfolio.

This "dual-fee" structure is the most commonly cited disadvantage of investing in funds of funds. However, criticism of the fees paid to managers of funds of funds ignores the fact that the due diligence, portfolio construction, diversification, and monitoring services provided by those managers could be much more costly if conducted by the investor directly. In fact, the cost efficiency of using funds of funds to perform these functions is a significant value proposition to investors, even without taking into account the value of the fund of funds manager's skill and experience.

In general, investors in funds of funds include institutions or individuals who want some exposure to hedge funds as a portion of their investment portfolios, but are either unable or unwilling to engage in the due diligence, portfolio assembly and monitoring process directly. These investors include high net worth individuals and smaller institutional investors who lack the skill or the resources to assemble a well-diversified portfolio of hedge funds. Fund of funds investors also include larger institutional investors with substantial skill and resources, who nevertheless prefer the efficiency of investing through funds of funds. Additionally, while most funds of funds are privately offered to qualified investors, a small number are publicly offered. To date, however, the SEC's practice has been to require publicly offered funds of funds limit sales of securities to persons who qualify as accredited investors.

Among institutions, pension funds are a significant and growing segment of the market for investments in funds of funds. Pension funds are subject to stringent fiduciary standards that require, among other things, the exercise of substantial care, skill, prudence and diligence. In order to fulfill these duties, many pension fund investment managers prefer to engage the skills of the professional fund of funds managers.

Funds of funds, like the hedge funds in which they invest, are often mischaracterized as unregulated investment vehicles. In reality, funds of funds operate under an array of federal laws and regulations. Because funds of funds are often, but not always, offered privately, they must comply with very specific statutory and regulatory exemptive provisions that govern private offerings. These provisions set out the criteria for the fund's offering, including how and to whom the fund's securities may be sold. Funds of funds and their managers must strictly comply with these provisions in order to carry out their operations.

The Fund

Funds of funds are often regulated in the same way as the underlying hedge funds in which they invest. Two provisions of the Investment Company Act of 1940 (sections 3(c)(1) and 3(c)(7)) exclude certain investment funds, including many funds of funds and hedge funds, from the definition of investment company, which means these funds are not required to register with the SEC. To qualify for the exemptions, these unregistered investment funds may only be offered privately to a limited number of institutions and high net worth individuals who meet the definition of "accredited investors" under section 3(c)(1) or "qualified purchasers" under section 3(c)(7).

Some funds of funds do register as investment companies under the Investment Company Act. In those cases, these registered funds of funds are subject to the same regulations applicable to registered investment companies, such as mutual funds, including registration of both their securities and their investment advisers with the SEC.

The Manager

Many, but not all, fund of funds advisers are registered with the SEC under the Investment Advisers Act of 1940, which entails a variety of obligations. For example, a registered investment adviser to a fund of funds must deliver a disclosure document containing a description of the type of funds in which the fund of funds invests. In addition, registered fund of funds managers are subject to SEC record-keeping rules and to periodic SEC examination. SEC examinations cover a number of areas, including pricing of holdings, performance fees, and disclosure of conflicts of interest. Investors in funds of funds managed by registered advisers are provided financial information subject to generally accepted accounting principles along with annual reports.

All fund of funds managers, even if not registered, are subject to antifraud provisions under the Investment Advisers Act, and all should have robust compliance programs.

The Offering of Interests in a Fund of Funds

When an investor purchases interests in a fund of funds, he or she is buying securities issued by that fund of funds. Generally, securities that are sold to the public must be registered under the Securities Act of 1933, unless they are exempt from registration by virtue of being offered through a private placement. Many funds of funds are offered through private placements in compliance with rules adopted under the Securities Act. These rules, known as Regulation D, limit the sale of unregistered securities to accredited investors, i.e., investors who generally have a net worth (including the primary residence) of at least US$1 million, or at least $200,000 in annual income.

Some funds of funds do register their securities under the Securities Act. However, the SEC's practice has been to require that the issuing fund of funds limit sales of its securities to persons qualifying as, at a minimum, accredited investors. Accordingly, it is inaccurate to suggest that funds of funds are contributing to a "retailization" of hedge funds by providing access to hedge funds to the general public. In reality, persons investing in funds of hedge funds, either privately or publicly offered, must meet the same eligibility criteria as persons who are permitted to invest in hedge funds directly.