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Hedge Funds of Funds - Do They Work? Part 3 on Hedge Funds

In part one, I wrote about the case for hedge funds. Then I wrote about the hedge fund investing perils in part two, concluding that they were too risky and expensive for all but the largest institutional investors. But can a small investor with only a few million get in the game effectively?

What is a Fund of Funds?
This is simply a fund that chooses to diversify risk by investing in several to more than a hundred different hedge funds. Thus, the goal is to obtain both low correlations to the stock market and an extra degree of diversification. Sounds compelling, right?

Fees - the outrageous becomes absurd
A typical hedge fund charges the "2 and 20" model with the house taking two percent annually plus 20 percent of the annual gain. Adding another layer of costs just makes it that much harder to gain a return above the "market."

Diversification can become your enemy
I'm nearly always for diversification since we don't really know the future. But this fee model actually makes diversification work against us. Here's an example.

Say you invest in Goliath fund of funds and that Goliath has a very low fee structure of two percent annually and doesn't take a part of the gain. Further, we will assume that the underlying hedge funds Goliath invests in uses the "2 and 20 model."

Goliath owns dozens of hedge funds and let's assume that two are futures oriented. Fund one uses leverage and bets on the dollar over the Euro. Fund two also uses leverage but bets on the Euro over the dollar. Obviously, one will win and the other will lose but they will net zero.

Let's assume that firm one makes 50 percent while firm two loses 50 percent. Under the "2 and 20" model, firm one charges 12 percent and firm two charges two percent. The average paid is seven percent plus the two percent take from Goliath.

What happened is that even though Goliath broke even before fees, this fund of fund pays out performance fees for those hedge funds that made money. The fact that the fund of funds lost money is irrelevant.

What the most successful hedge fund investor has to say
I don't want you to just take my word for the logic. David Swensen, the Yale endowment manager, is arguably the most successful investor in hedge funds. In fact, a good chunk of the popularity of hedge funds is due to his success. What does he have to say about fund of funds? Swensen speaks out as follows in a Wall Street Journal Interview:

Fund of funds are a cancer on the institutional-investor world. They facilitate the flow of ignorant capital. If an investor can't make an intelligent decision about picking managers, how can he make an intelligent decision about picking a fund-of-funds manager who will be selecting hedge funds? There's also more fees on top of existing fees. And the best managers don't want fund-of-fund money because it is unreliable. You need to be in the top 10% of hedge funds to succeed. In a fund of funds, you will likely be excluded from the best managers. [Mr.] Madoff also relied enormously on these intermediaries. He wouldn't have had nearly as much resources were it not for fund of funds.
Consultants make money by giving advice to as many people as possible. But you outperform by finding inefficiencies most of the market has not yet uncovered. So consultants ultimately end up doing a disservice to investors.

My advice
Hedge funds are great if you have the scale of a Yale or Harvard to negotiate lower rates than the "2 and 20" model. They make little sense for anyone with less than a billion dollar portfolio, which I suspect is most of us. The only thing that makes less sense than investing in a hedge fund, however, is pouring your money into a hedge fund of funds.

The case for hedge funds
The case against hedge funds

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