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 Hedge fund investment strategies are distinguished by their objective to deliver attractive returns that have a low correlation to traditional investments. The inclusion of a well diversified portfolio of hedge funds improves an investment portfolio’s risk/return in both bullish and bearish market environments. Diversification: Due to manager, sector and style risk, it is our view that individual hedge fund returns have an inherently high degree of unpredictability. To mitigate this unpredictability, we believe that a hedge fund portfolio should be highly diversified across individual managers, sectors and styles. Funds of Hedge Funds (FoHF) are subject to a layering of fees Single manager hedge funds generally charge a fixed 2% fee based on assets under management (AUM) plus 20% of profits/gains generated (performance fee). The performance fee is subject to continued positive performance. If the investment portfolio generates a negative return, the portfolio must recover the negative return before a future performance fee is paid. This is referred to as a “high water mark.” In addition to the above mentioned single manager hedge fund fees, FoHFs generally charge a fixed 1% AUM fee plus a performance fee of 10%. The layering of fees presents the question of the appropriateness of gaining one’s exposure to hedge funds through a FoHF. The answer to this question is based on the size of an investor’s hedge fund portfolio and the net performance and cost of the FoHF. First - What does a FoHF manager provide? Asset Allocation: There are approximately 20 core hedge fund strategies. Within these categories, there are numerous underlying styles. The FoHF manager provides an optimal mix of strategies and styles to target the investor’s risk/return objectives. Manager Selection: There are over 7,500 hedge funds. Smaller managers generally provide higher alpha so the task of screening, analyzing and developing a comprehensive list of qualified managers is time consuming. The FoHF manager provides the necessary analysis to arrive at an optimal mix of managers. What is a FoHF manager generally paid? Our assessment is if a FoHF meets a high alpha return target the FoHF manager will generate a total FoHF manager fee (both fixed and performance) of approximately three percent (3%). When does it make sense to incur these fees? Access Hedge Funds with Lower Balances: Single manager hedge funds generally have investment minimums of $250,000, $500,000 or $1 million. In order to meet these individual minimums and maintain a well-diversified portfolio a minimum hedge fund allocation of $5 million to $20 million is required. A FoHF provides a well-diversified portfolio at a substantially lower minimum. Generally, FoHFs have $500,000 minimums. Lower Overall Expense for Investors with Lower Balances: Unless an investor already has the necessary skills and resources to manage the complexity of a well-diversified hedge fund portfolio, the absolute expense of a FoHF can be more economical than building the necessary capacity to manage a self-directed hedge fund portfolio. We believe that for hedge fund balances of $15 million or less there is a compelling case to use a FoHF for cost efficiency reasons. Superior Performance: If the FoHF manager is capable of generating net returns superior to the returns that the investor could achieve on his or her own than the investor should be indifferent about fees regardless of the investor’s total hedge fund allocation. |
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