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Hedge Fund of Funds Investing: An Investor's Guide

ISBN: 978-1-57660-124-2
288 pages
January 2004
Hedge Fund of Funds Investing: An Investor


Hedge funds have rightly gained the attention of private and institutional investors in recent years, proving themselves as useful portfolio diversifiers and preservers of wealth while greatly dispelling their reputation as an "unsafe" investment. Yet investors attempting to navigate in the field of hedge funds face significant challenges: the large number of funds, the diversity of strategies used, the range of financial instruments traded, and the various formats for investing.

Pooling multiple hedge funds together into one vehicle, the fund of funds provides a ready solution, combining professional management expertise with asset allocation. In this book--the first of its kind--industry expert Joseph Nicholas shows investors how these funds operate, the benefits and risks, and the criteria and due diligence to utilize when selecting funds. Nicholas provides an in-depth analysis of historical fund performance and offers unique insight into the industry and trends that may affect its evolution.

Clear, insightful, and illustrated with numerous charts and graphs, Hedge Fund of Funds Investing is an essential resource for serious investors.
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Table of Contents


Part 1 The Fund of Funds Industry.
1 Fund of Funds in the Hedge Fund Industry.
Hedge Fund Investment Options.
Direct Investment.
Customized Portfolio.
Index Fund.
Fund of Funds Investment.
Growth of Funds of Funds.
Hedge Fund Industry Characteristics and Trends.
Hedge Fund Investment Structure.
Legal Structure.
Numbers of Investors and Minimum Investment Size.
Reporting and Disclosure.
2 Hedge Fund Investment Strategies.
Convertible Arbitrage.
Distressed Securities.
Emerging Markets.
Equity Hedge.
Equity Market Neutral.
Event Driven.
Fixed Income.
Market Timing.
Merger Arbitrage.
Relative Value Arbitrage.
Sector Long/Short.
Short Selling/Short Bias.

3 Fund of Funds Mechanics and the Two-Tiered Structure.
Structural Considerations.
Organization Structure.
Company Structure.
Subscriptions and Registration Exemptions.
Minimum Investment Size.
Lockup, Redemption, and Liquidity.
The Fund of Funds Management Company.
Manager Due Diligence and Selection.
Risk Management.
Performance and Exposure Reporting.

4 Advantages and Disadvantages of Funds of Funds Advantages.
Due Diligence.
Risk Management.
Portfolio Management: Strategy Selection and Manager Selection.
Access to Funds/Capacity.
Consolidated Reporting.
Exposure to Other Investors’ Cash Flows.
Lack of Control/Customization.
Decreased Transparency.

Part 2 Historical Performance of Funds of Funds.
5 Performance of Funds of Funds Fund of Funds Substrategies.
HFRI Fund of Funds Conservative Index.
HFRI Fund of Funds Strategic Index.
HFRI Fund of Funds Diversified Index.
HFRI Fund of Funds Market Defensive Index.
Fund of Funds Returns 1990-2002.
Fund of Funds Returns 1990-2002.
Fund of Funds Volatility 1990-2002.
Fund of Funds Volatility 1990-2002.
Fund of Funds Return Versus Volatility 1990-2002.
Fund of Funds Risk-Adjusted Returns--The Sharpe Ratio.
Sharpe Ratio 1990-2002.
Sharpe Ratio 2000-2002.
Preservation of Capital 1990-2002.
Fund of Funds Performance Versus Equities.
Fund of Funds Performance During Bear and Bull Markets.
Average Performance During Negative Periods and Positive Periods 1990-2002.
Return Distribution 1990-2002.
Fund of Funds Performance During Periods of Market Stress.

6 Fund of Funds in a Portfolio With Traditional Assets.
Linear Analysis of Returns.
Adding Funds of Funds to a Traditional Portfolio.
Achieving Superior Risk-Adjusted Returns.

Part 3 A Commonsense Approach to Selecting Funds of Funds.
7 Defining Objectives and Identifying Candidates Step 1: Define Objectives and Parameters.
Strategy Restrictions.
Structural Requirements.
Fund of Funds Objectives and Parameters Worksheet.
Step 2: Screen to Create a Funds of Funds Short List.
HFRI Fund of Funds Conservative Index.
HFRI Fund of Funds Strategic Index.
HFRI Fund of Funds Diversified Index.
HFRI Fund of Funds Market Defensive Index.

8 Issues in Due Diligence: The Fund of Funds Firm Background Information.
Staff Information.
Company Structure.
Asset Management Activities.
Product Information.

9 Issues in Due Diligence: Portfolio Management Asset Allocation/Style Selection.
Due Diligence Criteria in Manager Selection.
Portfolio Construction.

10 Issues in Due Diligence: Risk Management Transparency and Separately Managed Accounts.
Managed Account Structures.
Pricing Risk Case Study: Lipper.
Style Drift Case Study: Integral.
Risk Management.
Compliance and Legal Issues.

11 Fund of Funds Selection Case Study.
Step 1: Defining Investment Objectives and Parameters.
Step 2: Screening to Create the Funds of Funds Short Lis.t
Step 3: Conducting a Due Diligence Screen of the Funds of Funds Short List.
Step 4: Evaluating Finalists for Selection.
Final Selections.

Appendix A: AIMA Due Diligence Questionnaire. 
Appendix B: Excerpts from HFR Fund of Funds Industry Report.

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Author Information

Joseph G. Nicholas, JD, is founder and chairman of HFR Group, LLC, which includes HFR Asset Management, LLC, a fund-of-funds management company, HFR Europe, Ltd, an investment advisory firm, and Hedge Fund Research, Inc., a leading supplier of hedge fund data. Author of Investing in Hedge Funds and Market-Neutral Investing, he is a frequent lecturer and media expert on topics relating to alternative investments.
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"While hedge fund of funds have proliferated as a relatively new investment vehicle, reliable information about these vehicles has been limited. Joe Nicholas's timely book does a magnificent job of providing concise, valuable information about these popular new funds."
- Dan Rauchle
President, Wells Fargo Alternative Asset Management

"A creative and disciplined work that offers powerful insights into the fast-growing world of fund of funds investing and strategies. A quick and informative read for both the HNW and institutional investor."
- Lawrence Simon
President and CEO, Ivy Asset Management Corporation

"Hedge Fund of Funds Investing provides a thorough, well-articulated discussion of the key characteristics and issues associated with investing in a fund of hedge funds. I believe the frank disclosure of both the advantages and disadvantages of these vehicles, as well as the information on selecting a fund of funds, will make this book required reading for individual and institutional investors alike."
- Frank Belvedere, CFA, FCIA
Vice President of Alternative Investments, Montrusco Bolton, Montreal, Canada

This is a great reference for those who are just beginning to invest in hedge funds, as well as those who already have a hedge fund of funds allocation. If you are new to this investment vehicle, the book provides a thorough description of fund of funds and a great framework for conducting the due diligence process. If you are already invested in fund-of-funds, it will prompt you to ask some probing questions at the next meeting with your fund-of-funds manager."
- Cindy Koury
Senior Managing Director, Victory Capital Management

"Hedge fund expert Joe Nicholas dissects the industry's hottest trend, investing in fund of hedge funds, in his new book. It's a must-read for institutional and private investors alike."
- Joe Hershberger
Managing Director, Putnam Lovell NBF Securities Inc.

"Joe does it again! By taking complex and critical issues in hedge funds, he transforms them into the most accessible and readable form. Read it and reap."                                        - P. Morgan Kash
Senior managing director, Paramount Capital, Inc.
Board Member, Hedge Fund Association

"There has been tremendous growth in the fund of hedge fund business with assets doubling in the last year.  Joe clearly explains the reasons for this growth as he examines the hedge fund industry and assesses fund of hedge funds as the most effective way to gain exposure to the hedge fund arena. The book is a terrific resource for those considering an investment in hedge funds and/or a fund of hedge funds."
- Patricia Young
Managing Director and CIO, NewMarket Capital Partners, LLC

"Joe Nicholas has created an authoritative and innovative handbook of fund of funds investing that is essential for both financial and nonfinancial decision makers.  Building upon his previous writing, he has successfully applied his practical hands-on experience to demystify the hedge fund industry using common sense explanations that do not depend on obscure jargon or understanding."
- Sara Albrecht, CFA
Executive Committee and Trustee,  Museum of Contemporary Art, Chicago
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