Are Hedge Fund "Fund of Funds" Going to Become Obsolete?

First off, a quick definition before we launch into this article.

A hedge fund "fund of funds" (or FoF) is an investment fund that pools together large amounts of capital for the purpose of investing in various hedge funds.

Many high net-worth individual investors have been locked out of investing in certain hedge funds in the past, due to minimum investment requirements or a lack of contacts in the industry.

A number of pension funds and other institutions simply used FoFs because they didn't feel as though they had the expertise to invest in hedge funds themselves.

For instance, let's say that a high net-worth individual wants to invest in a SAC Capital Advisors fund.

He may have five million dollars to invest, but may be rejected due to a minimum investment requirement of $10 million dollars.

Also, he may be rejected on the basis that he doesn't have any contacts at the company, and SAC may be loathe to accept money from someone that they haven't worked with in the past.

Note: many hedge funds have recently changed their policies due to the economic downturn and implosion of the hedge fund industry, and would now gladly accept this investor's money with no questions asked. However, things were different just a few years ago, and many prestigious funds were reluctant to accept money from new and/or smaller investors.

Anyways, the Fofs took care of all of this.

The FoF would presumably be run by someone with a great deal of contacts within the hedge fund industry.

Also, the FoFs would be able to pool money together from various investors in order to be welcomed by the most prestigious hedge funds in the world. For instance, the individual investor with $5 million dollars may be rejected by SAC - however, 20 individual investors, investing a total of $100 million dollars ($5 million dollars each), would be much more likely to be welcomed into the club.

The FoFs, of course, took a cut. They would usually charge a 1% management fee, as well as an ADDITIONAL performance fee. Keep in mind that this was on top of the management and performance fees that the individual hedge funds (that they were investing in) already charged.

However, many investors and pension funds gladly paid this fee in order to be granted access to the largest hedge fund companies in the world. After all, many of these hedge funds were posting eye-popping gains, year after year, so the extra expense was a no-brainer.

However, things have changed.

The hedge fund industry has taken a beating over the past couple of years. Investors have exited the industry in droves. Funds that were previously close to new investment money are suddenly open once again.

The individual investors that were previously locked out of the industry are suddenly being welcomed with open arms.

Hedge funds are rolling out the red carpets for those $5 million dollar investments as they desperately try to stem the tide of capital outflows.

Individual investors and pension funds are suddenly questioning the wisdom of investing in these "fund of funds".

Why should we pay extra, they argue, if we can invest in these funds by ourselves?

Many large pension funds are choosing to now hire their own people to advise them on which hedge funds they should invest in. Given that they save the 1% management fee (and other fees) that a FoF would charge, they are still going to come out ahead in most cases.

In addition, by investing in these hedge funds themselves, they are able to gain greater access to the companies and have more accountability for their investments.

A major New York pension fund recently announced that they had significantly reduced their exposure to FoF investments.

The fund, which had $5 billion invested in FoFs just over a year ago, has scaled this number down to less than $500 million dollars.

I would expect this trend to continue, and I would also expect that many FoFs will find themselves unable to remain open due to an exodus of capital.

Filed under: Stock Market Education