A Fund of Funds is a Fund that mixes and matches the most successful Hedge Funds and other Mutual Funds and pooled investment vehicles, spreading investments among many different Funds or investment vehicles.
Hedge Fund strategies are complex and varied in their ranges of risk vs return. Even within a particular style, no two managers are likely to be exactly the same.
Each fund manager will apply different amounts of hedging or insurance to his/her portfolio and will employ different amounts of leverage.
A Fund of Funds simplifies the process of choosing Hedge Funds, blending together Funds to meet a range of investor risk vs return objectives while generally spreading out the risks among a variety of Funds.
This blending of different strategies and asset classesaims to deliver a more consistent return than any of the individual Funds.
Advantages:
A. Returns, risk and volatility can be somewhat controlled by the mix of underlying Funds.
B. Capital preservation is generally an important consideration.
C. Volatility depends on the mix and ratio of strategies employed.
Creating a Fund of Funds can be likened to baking a cake. Working from the same ingredients such as flour, butter, sugar, yeast, eggs, etc., a baker is capable of producing various different cakes.
So it is with a Fund of Funds. Understanding the characteristics and risk profiles of the different Hedge Fund strategies, allows the Fund of Funds manager to blend Funds together that often are able to produce fairly predictable returns.
Predictability of future returns is greater with a Fund of Funds!
In any investment strategy the predictability of future results is strongly correlated with the volatility of past returns of each strategy.
Future performance of strategies with high volatility is far less predictable than future performance of strategies experiencing low or moderate volatility.
Participants in the Mutual Fund industry, where the volatility of past results is high, know how impossible it is to predict future performance.
However, within the Hedge Fund industry many of the hedging strategies are able to produce consistent returns that are highly predictable.
As a result, focused Funds of Funds, utilizing some of these low-volatility strategies, are often able to produce predictable returns, not correlated to market direction.
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