Funds of Hedge Funds

A fund of funds is an investment partnership that invests in a series of other funds, the object being to diversify.

'fund of funds A unit trust belonging to an institution in which most of its funds are invested in a selection of other unit trusts owned by that institution. It is designed to give maximum security to the small investor by spreading the investments across a wide range.'
Oxford Dictionary of Finance and Banking, Third Edition, 2005

'Fund of funds: Investment partnership that invests in a series of other funds. A fund of funds’ portfolio will typically diversify across a variety of investment managers, investment strategies, and subcategories.'
Vault Career Guide to Hedge Funds, 2004

'Funds of hedge funds, hereafter funds of funds, do exactly what their name suggests—they allocate capital to several hedge funds. Investors buying shares in a fund of funds are not investing in a specific hedge fund, but rather gaining exposure to many different managers and strategies. Indeed, they acquire a proportionate share of ownership in a collective portfolio of typically 15–30 hedge funds.'
Hedge Funds: Myths and Limits, Lhabitant (2002)

'A "fund of funds" (FoF) is an investment fund that uses an investment strategy of holding a portfolio of other investment funds rather than investing directly in shares, bonds or other securities. This type of investing is often referred to as multi-manager investment.'

[fund of funds definition] 'A mutual fund which invests in other mutual funds. Just as a mutual fund invests in a number of different securities, a fund of funds holds shares of many different mutual funds. These funds were designed to achieve even greater diversification than traditional mutual funds. On the downside, expense fees on fund of funds are typically higher than those on regular funds because they include part of the expense fees charged by the underlying funds. In addition, since a fund of funds buys many different funds which themselves invest in many different stocks, it is possible for the fund of funds to own the same stock through several different funds and it can be difficult to keep track of the overall holdings.'

'A fund of funds is exactly what it sounds like. It is a mutual fund that invests in other mutual funds.'

[Fund of funds] 'A Fund of Funds, by definition, is one that invests in other hedge funds. Rather than investing in individual securities, a Fund of Funds invests in other hedge funds. Any fund that pools capital together, while utilizing two or more sub managers to invest money in equity, commodities, or currencies, is considered a Fund of Funds. Investors are allocating assets to Fund of Funds products mainly for diversification amongst the different managers' styles, while keeping an eye on risk exposure.
' http://www.hedgeco.net/fund-of-funds.htm

'A mutual fund that invests in other mutual funds.'

'A diversified portfolio of generally uncorrelated hedge funds.'

"In this paper we investigate whether it is possible for a fund of hedge funds to not only offer investors access to a diversified basket of hedge funds but to provide skewness protection at the same time. We study two different strategies. The first is for a fund to buy stock index puts and leverage itself, in line with the skewness reduction strategy proposed earlier in Kat (2002). In general, the latter strategy is too dependent on the actual asset allocation strategy followed by investors to allow a fund to be constructed that is optimal for all investors at the same time. However, for investors that invest more or less equal amounts in stocks and bonds and who keep their hedge fund allocation below 30% such a fund can indeed be structured. The second strategy is for a fund to buy put options on itself. We show that this does allow a fund to offer skewness protection to different types of investors at the same time, but compared to the optimal strategy the protection will be somewhat less accurate. Under both strategies the fund of funds is likely to incur a significant loss in expected return. As long as the hedge fund allocation stays below 30%, however, the loss of expected return on investors' overall portfolios will remain limited."
Kat (2002)

"This paper develops a portfolio construction model that is specifically designed for funds of hedge funds, incorporating specific controls for operational limitations, data biases and incompleteness. Absolute performance is targeted by selecting funds according to their alpha estimated with factor models. Whilst different factor models provide quite different estimates of a hedge fund's alpha, we can still use the ranking produced by them in the fund selection process. In an extensive out-of-sample historical analysis, funds of funds that are selected in this way and then allocated using constrained minimum variance optimisation are shown to perform much better than the equally weighted portfolio of all funds, or minimum variance portfolios of randomly selected funds. This is true even when hedge funds are selected according to their alphas produced by simple factor models. The best out-of-sample performance is obtained, out of the four factor models considered in this analysis, with the statistical factor model."
Alexander and Dimitriu (2004)

"We incorporate investor preferences for return distributions' higher moments into a Polynomial Goal Programming (PGP) optimization model. This allows us to solve for multiple competing hedge fund allocation objectives within a mean-variance-skewness-kurtosis framework. Our empirical analysis underlines the existence of significant differences in the return behavior of different hedge fund strategies. Irrespective of investor preferences, the PGP optimal portfolios contain hardly any allocation to long/short equity, distressed securities, and emerging markets funds. Equity market neutral and global macro funds on the other hand tend to receive very high allocations, primarily due to their low co-variance, high co-skewness and low co-kurtosis properties. More specifically, equity market neutral funds act as volatility and kurtosis reducers, while global macro funds act as portfolio skewness enhancers. In PGP optimal portfolios of stocks, bonds, and hedge funds, where equity exposure tends to be traded off for hedge fund exposure, we observe a similar preference for equity market neutral and global macro funds."
Davies, Kat and Lu (2005)