Question #45

Smaller family offices and high net worth investors benefit from FoFs as they enable access to top managers with smaller bite sizes and provide investment allocation guidance. Fees are substantially higher for FoFs, transparency generally lower, and there is no netting of performance fees, unlike multi-strategy funds. Netting of performance fees is an advantage since it may deny incentive payments to successful underlying funds when the overall performance of the FoF is poor. Therefore, not having netting is a disadvantage. Additionally, one of the advantages of FoFs is the economies of scale for monitoring. (Module 34.3, LOS 34.g) Glen Downing, CFA, recently took a new position as chief investment officer at Deep Dive Asset Management (Deep Dive), a hedge fund-of-funds (FoF) based in the Cayman Islands. Having worked only at mutual funds in the past, Downing is new to the hedge fund world and wants to get up to speed quickly to take advantage of what he believes to be exceptional market opportunities. Downing is particularly excited about the opportunities an FoF can offer, compared to that of individual hedge funds. The first fund Downing considers for investment is Copernicus Management (Copernicus), a hedge fund that invests in many different asset classes. Copernicus's team relies on a top- down approach to screening potential investments, and the team's choice is often influenced by current market conditions. Downing will compare Copernicus to others in its peer group, but is unsure of how to classify the fund. Another potential investment under consideration is APM International Advisors' global macro fund. APM management recently made the following claims during a sales pitch to Downing: Claim 1: "We tend to outperform other strategies in low-volatility markets." Claim 2: "Our strategies attempt to take advantage of markets that are not mean reverting." Claim 3: "Our high use of leverage—often in excess of 500% of capital—helps us to outperform other funds." Finally, Downing is interested in a recent pitch made by Esoteric Investors (Esoteric), a hedge fund specializing in volatility trading. Downing has summarized Esoteric's pitch, breaking out its purported advantages into three parts: Insurance-like returns. Downing feels that adding Esoteric to his FoF should provide Deep Dive an exposure to insurance-like returns, because Esoteric often is a seller of VIX futures contracts. Risk reduction. Downing believes that adding an allocation to Esoteric will reduce overall portfolio risk due to the negative correlation between its long-volatility contracts and equity market returns. Convexity. Esoteric's salespeople told Downing that the fund's long-volatility positions exhibit strong negative convexity—another added benefit.