Funds of Hedge Funds provide an interesting alternative to investing directly into Hedge Funds. Hedge Funds have become a favorite investment option for high net worth investors in Canada. While there are wealth limit restrictions against the average investor participating, the intent of hedge funds in general is to offer alternative investment strategies that are meant to preserve capital while generating growth. A hedge fund usually consists of a group of investors in a limited liability organization managed by a designated portfolio manager or investment management company. The strategies and trading actions of hedge fund manager determine the success of the fund. The manager’s compensation is usually based upon the profits generated by the investment performance.
In Canada, the hedge fund industry is considerably smaller than in the U.S. However, Canadian hedge funds are less cumbersome and far more flexible and responsive to market conditions. During some years, Canadian hedge funds have fared better than their U.S. counterparts. Lately Canadian hedge funds have enjoyed significant success, outperforming the broader market and many beaten-down U.S. hedge funds.
According to the Scotiabank Canadian Hedge Fund Index Asset Weighted Index, Canadian hedge funds enjoyed a 6.21% increase in 2015 while the broader market suffered a decline of 11.09%.
Hedge funds managers do not usually limit themselves to specific investment strategies, but prefer to embrace a range of investment alternatives to minimize overall risk and maximize gains even during periods of high market variation. In combination, a portion of the basket of investment are made to offset the potential risk of the balance.
One strategy involves investing in funds of other hedge funds. Let’s examine why this is viable.
What Are Funds of Hedge Funds in Canada?
A fund of hedge funds is clearly one that is made up of shares of other hedge funds. This type of investment does not rely solely on the expertise of one fund manager. Rather, funds of hedge funds are investments in a basket of hedge funds that may or may not have similar strategies.
Investing in a basket of hedge funds with varying strategies provides a diversification position that avoids the risk of “all eggs in one basket” in a volatile market.
In another scenario, some managers invest in several hedge funds that have similar strategies. In this case, investors (and manager) are aiming that the average gain among the group will be positive. Investing in single strategy fund of funds has the potential for greater return, but the risk is also far greater.
Why Invest in Funds of Hedge Funds?
Investing in funds of hedge funds is an appropriate strategy for an investor with enough capital to meet the base criteria for investing in hedge funds, but not enough to diversify significantly. Investopedia calls these funds of funds investments “High Society for the Little Guy”. The label is not necessarily accurate since many high worth individuals choose to allocate portions of their portfolio to this type of investment.
For example, assume $1 million is the minimum investment in any hedge fund. The investor who may only wish to expose $1.5 million would not be able to diversify much. By investing the entire $1.5 million in a single fund of hedge funds, the investor can achieve target diversification.
In addition, investing in funds of funds allows newer investors to safely try out the world of hedge fund investing before getting involve in funds with more targeted objectives.
Fees for Funds of Funds
There is usually an additional cost to investing in funds of hedge funds. In addition to the management and performance fees charged by the principal hedge fund manager, the secondary fund managers also charge their fees for the shares in their hedge funds. The investor’s assumption, as with any hedge fund, is that the diversification, safety and projected performance will more than justify the additional management costs of investing in multiple funds.
In the world of investing, there is never an absolutely “sure bet”. Hedge funds have performed well of late, better than the broader market and many of the U.S. funds. Diversification is the essence of hedge fund investing and funds of funds are a logical way to approach strategic investing.
But, as with all other funds, the insight and experience of the fund manager is the key success or minimizing losses. It is important to research the fund and the management strategy before investing.
We hope you found this article on Funds of Hedge Funds interesting. If you have questions about investing into a Canadian hedge fund we invite you to contact us today. It will be our pleasure to answer you questions.