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LOS r: Explain the purpose and special characteristics of fund-of-funds hedge funds. fficeffice" />

Q1. William Jones, CFA, has a client who wants to invest in a hedge fund. Jones might recommend a fund of funds instead of a single fund for all of the following reasons EXCEPT a fund of funds:

A)   would be more liquid.

B)   may serve as a better indicator of aggregate performance of hedge funds.

C)   would have a lower correlation with equity markets.

Correct answer is C)

Fund of funds are usually considered good choices for individual investors because they offer diversification, usually offer more liquidity, and suffer from less survivorship bias thus they may serve as a better indicator of aggregate performance of hedge funds. One problem with fund of funds is that they are usually more correlated with equity markets than an individual fund, and this lowers their ability to diversify the overall portfolio.

 

Q2. Style drift and survivorship bias are often mentioned in the analysis of hedge fund performance. Which of the following statements is most accurate? Fund of funds can serve as better indicators of aggregate hedge fund performance than hedge fund indices because they tend to have a lower level of:

A)   both survivorship bias and style drift.

B)   survivorship bias only.

C)   style drift only.

Correct answer is B)

A fund of funds may serve as a better indicator of aggregate performance of hedge funds (i.e., a better benchmark) because they suffer from less survivorship bias. If a fund of funds includes a fund that dissolves, the fund of funds includes the effect of that failure in the return of the fund of funds; however, an index may simply drop the failed fund. A fund of funds can suffer from style drift. This can produce problems in that the investor may not know what he/she is getting. Over time, managers may tilt their respective portfolios in different directions. It is not uncommon that two fund of funds who claim to be of the same style to have returns with a very low correlation.

 

Q3. With respect to hedge fund investing, the net return to an investor in a fund of funds would be lower than that earned from an individual hedge fund because of:

A)   no reason; fund of funds earn returns that are equal to those of individual hedge funds.

B)   the extra layer of fees only.

C)   both the extra layer of fees and the higher liquidity offered.

Correct answer is C)

Fund of funds are usually considered good choices for individual investors because they offer diversification and usually more liquidity. One problem with fund of funds is that they usually have lower returns. This is a result from both the additional layer of fees and cash drag (resulting from a desire to have higher liquidity).