Fund of Funds Risks and Pitfalls

Alternatives are an attractive asset class that merits investor attention. However, due to the large investment minimums required to gain access, some investors have lacked the ability to diversify properly within this attractive asset class.

A Fund of Funds structure offers a way for investors to diversify within this investment space. But there are numerous risks and drawbacks in choosing this model as your alternatives solution.

A Fund of Funds is described quite well by its name. Investopedia describes it as:

[A] pooled investment fund that invests in other types of funds. In other words, its portfolio contains different underlying portfolios of other funds. These holdings replace any investing directly in bonds, stocks, and other types of securities.

Investopedia also states that a Fund of Funds could be described as a multi-manager investment.

Fund of Funds Structure

As previously mentioned, Fund of Funds can offer the ability to invest in a multitude of alternative investments simultaneously.

But there are other potential benefits. One of these is the ability to set-it-and-forget-it.

While there is more of a risk in putting all your trust in one manager, having confidence in one Fund of Funds manager to watch markets and continuously evaluate hosts of different alternative investments can make advisors and their clients’ lives easier. The difference between trusting one manager to evaluate the investment landscape and evaluating an entire menu of different managers can be the difference between taking on a second full-time job (evaluating fund managers) and having peace of mind! This still requires proper due diligence when choosing the original Fund of Funds manager but allows one to entrust the remaining investment process to another manager.

Other potential benefits, which can vary depending on the Fund of Funds you are working with, can come from pre-existing relationships of the fund managers. Sometimes, great managers in the alternative investment market may close their funds to new investors. Fund of Fund managers might be able to leverage their existing relationships to help gain access to investment opportunities that may not be available otherwise.

There are numerous shortfalls to the Fund of Fund’s model of investing in alternatives. Chief among these drawbacks are the fees that Fund of Funds charge, which may even include performance fees.

A study by Columbia University and the National Bureau of Economic Research states that, within this investment vehicle, management fees of 1.5% and performance fees of 10% are common.

These fees are a big hurdle to get over in order to beat the overall market. For this reason, the SEC adopted extra investor protections in 2006 to ensure that Funds of Funds were properly marketing and explaining the fees being charged. The SEC stated:

“The amendments improve the transparency of the expenses of funds of funds by requiring that the expenses of the acquired funds be aggregated and shown as an additional expense in the fee table of the fund of funds.”

Lack of Transparency: Many Fund of Funds come with transparency issues. Frequently, alternative managers extoll their process for selecting great investments. This is fine enough when attempting to evaluate a single manager and invest, but when a fund structure is used to invest in other funds, it can be more difficult to evaluate the different investment decisions that a manager is making.

Illiquidity & Pooled Liquidity: Another issue that comes to mind is liquidity. Or rather, the lack of it. Alternatives are generally less-liquid investments than your normal stock or bond that can be traded daily. Adding in the extra step of investing in a fund that invests in other funds, and you have just added two hurdles towards retrieving your money.

Hedge Funds usually have quarterly redemptions, and you can expect a similar redemption process from funds of funds. But even if you are happy with your Fund of Funds Manager, they will still have delays in redeeming one of their investments when they inevitably see a better opportunity present itself.

Investors in a Fund of Funds often have less liquidity than a traditional hedge fund, given that the fund of fund manager will need to match the redemption cycle with the underlying funds in the portfolio. For example, if a Fund of Funds manager has 4 funds with semi-annual, monthly, quarterly, and annual redemptions, the portfolio will likely provide either annual or semi-annual liquidity to match with the less-liquid funds, even though an underlying fund offers investors a chance to get out each month.

Keeping with the liquidity theme, the pooled nature of liquidity can also be an issue. Illiquid investments often trade at a discount, offering patient investors a risk premium and larger returns. But pooling your money into a fund may mean that you are investing alongside other LPs who are not willing to invest in less liquid investments, dragging down your returns.

Overdiversification: Funds of Funds are ‘one size fits all’ and tend to be overly diversified, which often results in diluted returns.

Alternative investments often require large minimum investments to access. Funds of Funds offer a way to diversify across this asset class and gain access without concentrating one’s risk in one investment vehicle.

See how Crystal offers an alternative to Fund of Funds and a different way by allowing you to choose how you access this exclusive asset class.