Lesson 6 of 8 · 12 min
Investing indirectly: funds of funds and replication ETFs
Smaller investors reach hedge funds indirectly, through funds of hedge funds that add diversification, access and liquidity at the cost of a second layer of fees, or through liquid ETFs that imitate hedge fund returns without holding hedge funds.
In short
- Indirect routes serve smaller institutions and larger retail investors, those lacking specialist skills, and those wanting several strategies at once.
- A fund of hedge funds (FoHF) offers diversification across strategies, regions and styles, lower minimums, shorter lockups and better exit liquidity.
- Cost: fee layering, often about 1% plus a 10% incentive fee on top of the underlying funds' fees, usually computed on profits net of management fees at both levels.
- FoHF managers add due diligence, monitoring, access to closed funds and better negotiated terms; but their extra liquidity can force selling in turmoil.
- Hedge fund replication ETFs use liquid securities and quantitative models to mimic hedge fund returns: cheaper, more liquid and transparent, but with less leverage and usually lower returns.
- Liquidity spectrum, least to most liquid: limited partnerships, SMAs, closed-end funds, mutual funds, ETFs.
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