Fund Of Funds

Hedge fund of funds

Since hedge funds are able to go long and short on securities, they can potentially profit in any market environment, including one with sharply declining prices. Hedge funds are becoming increasingly desirable to high-net worth investors; demand is rising. The Financial Times reported in May 2002 that the hedge fund market had been growing at 40% per year since 1997.

If your goal is to achieve consistent returns and lower volatility, using groups of diversified hedge funds packaged together may be a good option. FOFs offer you the benefits of diversification, potential for enhanced returns, and lower volatility. But you do have to pay an extra layer of fees: In addition to the fees for each hedge fund, you have to pay the FOF fee.

Properly structured FOFs comprise various diversified strategies, which enable them to grind out returns over time. However, there are no assurances that this strategy will work, because hedge funds and FOFs have a myriad of risks associated with them as well as benefits. The risks have to do with liquidity, diversification, credit risk, analysis risk, and even taxes.

Fund of funds strategies

Here are the various strategies employed by funds of funds:

• Convertible arbitrage: Involves buying convertible bonds and selling short the underlying common stock. Some degree of leverage is normally used.
• Distressed securities: This strategy attempts to identify securities of companies that are under pressure due to a particular event, such as a bankruptcy or corporate reorganization.
• Emerging markets: Looks to invest in securities of companies or the sovereign debt of developing countries.
• Long/short equity: Involves holding a portfolio of long and short stock positions. The strategy could involve an equity market-neutral approach where short positions offset long positions in like sectors. Many long/short programs are net long (equity hedge), while attempting to offset long exposure. Others (equity nonhedge) make a directional bet on the market with short positions. This latter group includes commodity trading advisors (CTA) who apply trend-following principles to equities.
• Event-driven: Invests in opportunities created by corporate events such as spinoffs, mergers and acquisitions, bankruptcies, recapitalizations, and share buybacks. (These are also known as "special situations.")
• Fixed-income arbitrage: Attempts to profit from inefficiencies between related interest-rate securities. Managers speculate on the cash/futures basis, yield curve, interest rate swaps, and US versus non-US government bond yields.
• Global macro: Managers can be long or short in a variety of financial instruments. The strategy often will deal in stocks, bonds, and currencies on a global basis and has been dominated by high-profile managers who have developed strong reputations, which affords them greater discretion. Global macro programs have lost favor in the last decade, giving ground to more market-neutral strategies.
• Managed futures: There is a debate over whether CTAs represent a class of hedge funds. CTAs typically are trend-followers who trade commodity, equity, financial, and currency futures contracts. Managers can trade from a technical or fundamental perspective, long term or short term, using a systematic or discretionary method.
• Merger arbitrage: Also known as risk arbitrage, this approach usually involves buying stock in a company that is the target of an acquisition and selling the acquirer's stock. Managers often use equity options to limit risk.
• Relative value arbitrage: Attempts to exploit pricing discrepancies between relationships in equities, debt instruments, options, and futures.

• Sectors: Funds that use various strategies but invest in a specific sector such as energy, financials, healthcare, or technology.
• Short selling: Involves selling short stock in companies the manager believes will decline. Short sellers were hurt badly in the 1990s, but this has been among the most successful strategies over the last two years. A liquid single-stock futures market could enhance this strategy, allowing managers to sell stock futures short without the need to borrow against the position.
• Statistical arbitrage: This is a low-risk strategy that uses mathematical models to find inefficiencies between related stocks. Positions are market, industry, and dollar-neutral.

General descriptions

There are many variations and intricacies for the following strategies, but here are some general descriptions.

A simple analogy: just as any prudent investor should not invest in a single stock or mutual fund, prudent investors in hedge funds should not just invest in a single manager. However, the majority of hedge-fund managers maintain minimums in excess of $1,000,000 or more. Even for high-net worth investors, it can be financially prohibitive to invest in enough funds to ensure proper diversification.

A well-thought-out product in an FOF format should incorporate the following:

An experienced and knowledgeable advisor of an FOF should demonstrate:

• Due diligence and judgment
• Qualitative evaluation
• Strong communication with managers and affiliated entities
• A habit of reference-checking.

Manager selection could include:

• Experienced investment professionals with demonstrated performance
• Nascent stars in their field of specialization
• Expectation of an ongoing ability to exceed peer groups
• Diversification
• Portfolio structure based on noncorrelation of returns among component funds
• Strong researchers
• Extensive use of databases that maintain a performance analysis platform
• Quantitative evaluation of historical performance
• Risk analysis.

Selection criteria could include:

• Managers whose goals include preservation of capital and who employ a risk/return profile that looks to avoid taking extraordinary risks in order to generate returns
• Managers with very strong professional and educational backgrounds
• Managers with a history of making money for themselves and others
• Managers who invest their own capital in their partnerships alongside their investors.

Even after this diligent selection process is complete, a constant monitoring of each manager is crucial for success. This due diligence is often too time-consuming for individual investors, and sometimes even too time-consuming for financial advisors. Due to the intricate nature of hedge fund strategies, you may have to analyze hundreds of funds before you make a selection.

Andy Abraham is a registered investment advisor with Abraham Bedick Capital, based in Florida. He has been in the investment field since 1991, and is currently comanager of a fund of funds called AB All Weather Fund. He can be reached at 954 608-6774, A.Abraham@AbrahamBedick.com, or via www.AbrahamBedick.com.

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