Funds of hedge funds (FoHF) have become a popular way for new hedge fund investors, both private and institutional, to gain access to the attractive performance characteristics of hedge fund strategies. These products provide investors with efficient exposure to a diverse range of alternative investment strategies and the unique skills of different advisers through a single vehicle.

The investment manager
The success of any FoHF product is highly dependent upon the skill of the investment manager and therefore it is crucial to select a manager with a clear competitive edge. Investors should look for an investment manager with considerable experience in the hedge fund industry and a proven ability to construct and manage a FoHF portfolio.
Increased demand for FoHF products has led to the emergence of numerous new and untested hedge fund managers. These include financial professionals from traditional fund management companies and other areas of the investment community. New entrants to the FoHF arena should be treated with caution until they prove their alternative asset management capabilities. It remains that growing numbers of hedge funds offer more variety but do little to simplify the due diligence and selection process.
Achieving and maintaining optimal diversification among different hedge fund strategies and advisers is not easy for the individual private investor. The advantage of investing in a FoHF is that this responsibility is taken care of for you.

Potential for efficient diversification through a single vehicle
Sophisticated investors recognise the need to reduce losses by diversifying their portfolios. An important aspect of diversification is to avoid placing too much money with any particular investment or fund manager. The advantage of investing in a FoHF is that diversification may be achieved for you.
q Diversification among strategies Typically a FoHF will include investments in a number of different strategies. These strategies aim to exploit different market opportunities. Combining a range of strategies creates the potential to make money in a wide range of market conditions and reduces the risk of over-exposure to any particular style of investing.
q Diversification among advisers To provide an additional layer of diversification, a FoHF will typically invest in a number of different advisers. These advisers possess different strengths and are skilled in different investment areas. Harnessing the competitive advantages offered by each adviser’s investment process extends the range of profit opportunities and reduces the risk of over-reliance on too few advisers.

Professional portfolio management
q Selection and portfolio construction The universe of hedge fund advisers and strategies is vast. A good FoHF manager has the experience and judgement needed to conduct due diligence and select advisers and strategies that complement each other to achieve optimal diversification. A portfolio with the right mix of advisers and strategies can help achieve the right balance of growth and risk prevention.
q Monitoring and risk management A FoHF portfolio needs to be adjusted to reflect the changing risk and reward profiles of different strategies and advisers. Through the monitoring and regular communication with advisers a FoHF manager can anticipate potential problems and capitalise on new opportunities as they develop. This can help to maintain a smooth and impressive return stream.

The strategies employed by a FoHF portfolio typically enjoy a lack of correlation with each other and seek to exploit different market inefficiencies, therefore some strategies may outperform others over a given time period. By allocating to a wide range of strategies, FoHFs seek to smooth out periods of above and below-average performance by individual strategies and generate a more stable return stream. The performance potential of FoHF is highlighted here by the track record of an established FoHF index. What is notable is the consistency of the manager’s performance throughout a range of market conditions spanning the last one and a half decades. By combining complementary investment strategies and advisers, a FoHF product can offer risk-adjusted returns with little or no correlation to the performance of traditional assets.

Portfolio enhancement
With the onset of the equity bear market, many investors with portfolios consisting purely of traditional stock and bond investments have suffered major losses. The way in which FoHF products have managed to preserve, and in some instances grow, investors’ portfolio assets throughout the recent market downturn is a testament to the diversification benefits they can provide. Given the valuable diversification benefits a FoHF product can offer, an increasing number of prudent investors are turning to FoHFs in an effort to improve the overall risk/reward profile of their investment portfolios.
While it is not possible for investors to eliminate all risk from their investment portfolios, steps need to be taken to reduce risk to tolerable levels, and including a FoHF product can be a way of doing this. Although FoHF products often share similar target returns and volatility levels, the investment process and experience of FoHF managers may differ significantly. These factors should be considered before one decides to invest in a FoHF product.
Mark Chambers is head of sales management – Europe at Man Investments, based in London. Prior to joining Man Investments in late 1994, he was head of OTC equity derivatives and director of new products at Daiwa Securities. Chambers has been involved in investment banking and fund management for 25 years and has also worked for Merrill Lynch, Dean Witter Reynolds and Drexel Burnham Lambert.

This material is communicated by Man Investments Ltd, which is authorised and regulated by the Financial Services Authority