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A Hedge Fund Chronology continued...



Part two of a three part series.

see Part one.

One of the greatest contributors to superior risk adjusted returns is the ability to be completely out of a market when prices don't make sense, something designated funds don't normally do. For example, we have sold our entire convertible bond portfolio several times in two years because we felt the prices were too high. This is playing defense simply by not playing offense. It is considering cash as an asset class, one used when waiting for the right opportunity. If there are no opportunities, we are in cash.

Hedge funds that solely trade convertible bonds or any other specific strategy would rarely do this; after all, they are being paid (at least in their own minds) to stay in the strategy by their investors. And this is at least partially true, which leads us to Funds of Funds.

A Fund of Funds is descriptive of what it is: a fund set up to invest in other hedge funds. It takes in money and acts as a fiduciary, either advising or acting as principal to allocate that money to different hedge funds.

One advantage of a Fund of Funds is that it has an experienced (to a certain degree) staff that will do what is called "due diligence" on a potential hedge fund. It will do background checks on managers and thoroughly investigate their specialized strategy for competence.

Another advantage is that because such a fund has a lot of money, it has relationships where it can access certain popular hedge funds that individuals (or individual sources) cannot. The Fund of Funds often partners with banks and brokerage firms, who have large numbers of wealthy and fairly sophisticated clients: together they create a vehicle through which these clients can invest.

Another advantage is closely related. Because of its size and relationships, it pools the money from investors and allocates portions to different types of hedge funds in order to create a diversified portfolio of hedge funds. It also tends to get more transparency than smaller sources of money if it promises not to pass this transparency on to the ultimate investor. It can therefore perform some limited analytics to forewarn against certain basic risks. The primary risk that it looks for is concentration risk: is any one manager or the portfolio as a whole too concentrated in any one thing.

I view this potential risk as possibly serious, but also one that if not properly analyzed, can be misleading. If there is an opportunity where the return for risk is excellent and the extraneous risks can be effectively controlled, shouldn't that opportunity be executed on a larger rather than smaller basis? Experience is the key here and this leads into the drawbacks of Funds of Funds.

NOTE: Please understand that this is not a solicitation of any kind. We share the process with you for the sole purpose of education. Stay tuned for part 3 of 3.

No positions in stocks mentioned.

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