Disadvantages of Funds of Hedge Funds

I wanted to share a short piece outlining some of the disadvantages to fund of hedge funds. This is informed by speaking with allocators and family offices about their investment portfolio and strategies and for educational purposes only.

We have written previously about the benefits to funds of hedge funds for certain investors but with the way the hedge fund industry has evolved, we tend to hear a lot more about the negatives. I’ll be discussing the fund of funds model along single manager strategies on a panel I’m moderating at our Single Family Office Summit (REGISTER HERE) and I welcome a discussion beforehand by those in my network who may have strong opinions on fund of funds.

Disadvantages of Fund of Hedge funds

While funds of hedge funds can help investors realize great returns while outsourcing the due diligence required of intelligent investing, there are many disadvantages associated as well. Problems that arise with fund of funds can include limited liquidity, exposure to industry-wide trends, and less control and customization. Funds of hedge funds can have multiple shortcomings.

An important aspect of investing is liquidity, the ability to transfer your money in and out of one investment. For hedge fund investors, this can be particularly problematic because hedge funds often have limited liquidity. This means that a fund will only allow its investors to redeem their investment at certain times during the year; the most common intervals being monthly, quarterly, and annually. In order to cash out the investment, an investor must submit a redemption notice to the fund for the next available redemption date and funds will often require that you submit this notice at least 30 days prior to that date.

Limited Liquidity

Liquidity may seem like a minor concern but it can quickly become a big problem for investors. In addition to the more common reasons for withdrawals, such as poor performance or a rebalancing of the investor’s portfolio, there are a number of hard-to-predict events that can arise. To name just a few possibilities: the investor could have a medical or financial emergency that requires the money allocated to the fund; the fund manager could become seriously ill or die unexpectedly; or a significant part of the management team could leave the fund to start their own fund. All of these events could place your capital at significant risk and will probably make you wish that you could redeem your money as easily as you can in a common stock investment. Funds of hedge funds are similar in their limited liquidity because they have allocated to hedge funds with varying redemption dates and many funds of funds thus impose similar redemption requirements and even lock-ups. Investors should take liquidity into account when considering a hedge fund or fund-of-hedge-funds investment.

Exposure to Industry-Wide Trends

A fund of hedge funds can diversify an investor’s exposure to single-manager or single-strategy risks, but investors will likely still have some exposure to hedge fund industry-wide trends. For example, hedge fund performance was sluggish in 2011 to 2012 with many analysts pointing to volatility in the markets as a primary cause of the lackluster returns. A struggling global economy, the European sovereign debt crisis, and fiscal negotiations in the United States all helped contribute to extreme volatility in recent years. Such widespread trends can have an impact on hedge funds even those in otherwise minimally correlated strategies. Thus, we can see that overall economic or industry-related trends can affect the returns of even a highly diversified portfolio of hedge fund investments.

Less Control and Customization

For those who prefer to have complete control and transparency with their investments, a fund of hedge funds presents a few problems. For one, in most cases, the fund of hedge funds is actively managed for the benefit of multiple investors and the management team may make decisions that are contrary to what the investor would prefer. For example, the investor may have a greater risk appetite than the other investors in the fund or than the fund of hedge funds management team thinks is appropriate given the market conditions. This lack of customization and control can be frustrating, especially for seasoned investors who are used to having complete control over the management of their investments. Still, for many fund-of-hedge-fund investors, this hands-off approach to investing is a benefit as it allows greater peace of mind knowing that a team of investment professionals is responsible for the performance of the fund.

Less Transparency

In a fund of hedge funds, the investor does not have a relationship with the hedge funds that make up the portfolio. This is seen as a disadvantage because the investor is less engaged with the investment and may have less insight into the operations and management of each hedge fund. This oversight is delegated to the fund of hedge funds and the investor is largely expected to trust the judgment and abilities of the fund-of-funds management team. For investors, this can be a frightening prospect, especially in light of recent scandals and frauds where many investors were only vaguely aware that their fund-of-funds or feeder-fund vehicles had invested in risky or fraudulent investments. It is therefore incumbent on the investor to only select a fund of hedge funds that he feels can adequately perform the due diligence, compliance, monitoring, and other duties required of hedge fund investing.

Do you have a strong opinion on this? We’re always discussing industry trends at the Hedge Fund Group on LinkedIn if you’re not a member. I’ll be putting this up for debate there, too, if you want to join in (free): http://www.LinkedIn.com/e/gis/44059/5FC1F8699305

Theodore O’Brien
Managing Director
Hedge Fund Group
Certified Hedge Fund Professional (CHP)
[email protected]
77 Harbor Drive #76
Key Biscayne FL 33149

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