Fund-of-Funds: How They Change Alternative Investment Risk-Return

Fund-of-funds (FoFs) in alternative investments fundamentally reshape the risk-return characteristics compared to direct investments in assets like hedge funds, private equity, or real estate. Imagine constructing a diversified stock portfolio by individually selecting dozens of stocks versus investing in a mutual fund that holds a basket of stocks. FoFs operate similarly in the alternatives space, acting as intermediaries that invest in a portfolio of underlying alternative investment funds rather than directly into the assets themselves. This structural difference has profound implications for both risk and return.

One of the most touted benefits of FoFs is diversification. By allocating capital across numerous underlying funds, often employing different strategies, geographies, and managers, FoFs inherently spread risk. This diversification aims to mitigate idiosyncratic risk – the risk specific to a single manager or investment strategy. For instance, if an investor directly invests in a single emerging market hedge fund and that fund underperforms due to a manager’s error or market event, the entire investment suffers. However, within a FoF, such an underperformance is diluted by the presence of other, hopefully better-performing, funds. This portfolio effect can lead to a smoother, less volatile return stream compared to the potentially sharp swings of individual alternative investments.

However, diversification within a FoF is not without its complexities. Manager selection risk becomes paramount. The success of a FoF hinges critically on the skill of the FoF manager in identifying and selecting superior underlying funds. Poor manager selection can negate the diversification benefits, leading to a portfolio of mediocre or underperforming funds. Furthermore, excessive diversification or ‘diworsification’ can occur if the FoF invests in too many funds with overlapping strategies, diminishing the true diversification effect and potentially diluting returns. The skill and due diligence process of the FoF manager are therefore crucial determinants of the risk-adjusted returns.

Another key modification arises from fee structures. FoFs introduce an additional layer of fees on top of the fees charged by the underlying funds. This “fee layering” can significantly impact net returns. Investors effectively pay twice: once to the underlying fund managers and again to the FoF manager. To justify these additional fees, FoFs must demonstrate their value-add through superior manager selection, strategic asset allocation across different alternative strategies, and potentially providing access to top-tier funds that might be closed to direct investors. The hurdle for FoFs to outperform direct investment, after accounting for these extra fees, is consequently higher.

In terms of return characteristics, FoFs often aim for more consistent, albeit potentially lower, returns compared to direct investments. While the diversification effect can dampen volatility and reduce the likelihood of significant losses, it also caps the potential for outsized gains. The best-performing underlying funds within a FoF are effectively averaged out with the performance of other funds, including potentially less stellar ones. Therefore, investors seeking to maximize returns might find FoFs less appealing, as they are essentially trading off some upside potential for reduced downside risk and smoother returns.

Liquidity is another dimension affected by FoF structures. Alternative investments are generally illiquid. FoFs, while still subject to liquidity constraints, can sometimes offer marginally improved liquidity compared to direct investments in individual funds, particularly those with longer lock-up periods. However, this is not guaranteed and depends on the liquidity terms of the underlying funds and the FoF’s own structure. Ultimately, liquidity remains a significant consideration in both direct alternative investments and FoFs, though FoFs may offer a slightly more manageable liquidity profile in certain scenarios due to portfolio diversification and active management.

In conclusion, fund-of-funds in alternative investments fundamentally alter the risk-return landscape. They offer diversification benefits, potentially smoother returns, and access to a curated portfolio of managers, but at the cost of additional fees, potential dilution of top-end returns, and reliance on the FoF manager’s skill. Investors must carefully weigh these trade-offs, considering their specific risk tolerance, return objectives, and the expertise of the FoF manager, to determine if a FoF structure aligns with their investment strategy in the alternative investment space.