Three main approaches are used to combine individual hedge fund strategies into a portfolio:
- creating one’s own mix of managers by investing directly into individual hedge funds running different strategies
- fund-of-funds, which involves investing in a single fund-of-funds manager who then allocates across a set of individual hedge fund managers running different strategies
- multi-strategy funds, which entails investing in a single fund that includes multiple internal management teams running different strategies under the same roof
Fund-of-funds (FoF) managers aggregate investors’ capital and allocate it to a portfolio of separate, individual hedge funds following different, less correlated strategies.
FoF have the following benefits:
- Diversification across hedge fund strategies.
- Expertise in individual manager selection.
- Strategic allocation and style allocation.
- Due diligence.
- Occasional value-added tactical decisions.
- Currency hedging.
- Leverage at the portfolio level.
- Better liquidity terms vs. individual hedge funds.
- Access to certain closed hedge funds.
- Economies of scale for monitoring.
- Research expertise.
- Potential liquidity efficiencies.
- Potentially valuable concessions from the underlying funds.
FoF have the following disadvantages:
- A double layer of fees for the investor.
- Lack of transparency into individual hedge funds.
- No performance fees netting.
- Additional principal–agent issues.
Multi-Strategy Hedge Funds
Multi-strategy hedge funds combine multiple hedge fund strategies under the same hedge fund structure. Teams of managers dedicated to running different hedge fund strategies share operational and risk management systems under the same roof.
- FoF and multi-strategy funds are designed to offer steady, lo
- w-volatility returns via their strategy diversification. Multi-strategy funds have generally outperformed FoFs but with more variance and occasional large losses often related to their higher leverage.
- Multi-strategy funds offer potentially faster tactical asset allocation and improved fee structure (netting risk handled at strategy level) but with higher manager-specific operational risks. FoFs offer a potentially more diverse strategy mix but with less transparency and slower tactical reaction time.
- Both groups typically have similar initial lock-up and redemption periods, but multi-strategy funds also often impose investor-level or fund-level gates on maximum redemption allowed per quarter.
- Multi-strategy funds tend to use significantly more leverage than most FoFs, which gravitate to modest leverage usage. Thus, multi-strategy funds are somewhat more prone to left-tail blow-up risk in stress periods. Still, better strategy transparency and shorter tactical reaction time make multi-strategy funds overall more resilient than FoFs in preserving capital.