NEW YORK (CNN/Money) -
Hedge fund strategies used to be accessible only to the ultra-wealthy, but now, anyone with an annual income of $200,000 can buy entry into a "fund of funds," an investment fund tied to hedge funds, for as little as $25,000.
This may seem like good news to many investors, who are hearing the siren call of hedge funds because of disappointing returns in other asset classes. But is this kind of fund a good investment for hedge fund newbies?
The answer depends on how much money you have and how much risk you're willing to take.
A fund of funds is simply a portfolio of individual hedge funds. Some funds of funds are strategy-specific, so that you can buy a portfolio of long/short equity hedge funds. Others are more diversified. But all of them provide exposure to hedge funds, which generally won't take less than $500,000 for a direct investment.
"If you have enough money and know what you're doing you could save money by investing directly in hedge funds, but those are two major 'ifs'," said Benjamin Poor, senior analyst at Boston-based research and consulting firm Cerulli Associates. "If you wanted to put money in a pool of diversified managers as part of your overall strategy, you'll need tens or hundreds of millions of dollars to do that effectively."
Hedge funds for the little guy
Many funds of funds require minimum investments in the hundreds of thousands of dollars, but some firms are launching funds that give investors exposure to hedge funds at a much lower cost of entry.
Last fall, Credit Suisse registered a series of funds of funds with the Securities and Exchange Commission; these require minimums of $50,000, as does J.P. Morgan's Multi-Strategy hedge fund and Deutsche Bank's DB Hedge Strategies fund. Merrill Lynch's Multi-Strategy Hedge Opportunities Fund requires a $25,000 minimum, as does Rydex's registered fund of funds.
But these low-minimum funds of funds have drawn mixed reactions from hedge fund experts, who say that some look a bit too much like mutual funds to add value to an investor's portfolio.
"The number of managers and the underlying cost structure gets to be very similar to a mutual fund," said Mark Bloom, managing partner of MB Investment Partners, a New York-based wealth management firm.
Magnus Olsson, head of hedge funds at London-based money manager London & Capital, said the more "underlying" managers in a portfolio, the harder it is to monitor them.
"That's a big part of what we do," he said. "To be on top of what's going on with the manager and the strategy, you need to have a limited amount of managers."
Fees of fees?
The most commonly-cited drawback to funds of funds is that they charge an extra layer of fees. Any gain investors earn from underlying hedge funds will only be assessed after each fund manager has taken a 20 percent cut of gains, plus management fees of one to two percent. Funds of funds managers typically charge another 10 percent for performance and another one percent for management.
Poor said fund of funds are a smart move for first-time hedge fund investors despite the fees because it's hard, even for experienced investment professionals, to judge who is a good hedge fund manager.
"Even some sharp folks like advisers and investment consultants typically don't have a high degree of expertise in analyzing hedge fund managers," he said. "You need to have been a former trader or portfolio manager to fully appreciate what some of these hedge funds are doing."
Randy Shain, co-founder of investigative due diligence firm BackTrack Reports, said fund of funds managers provide a critical layer of due diligence between the hedge fund managers and investors. Shain said funds of funds use his firm's services to do background checks on hedge funds and said he is impressed with how rigorously they screen potential investments.
Said London & Capital's Olsson, "We need to know exactly what the manager is doing and if they will let us see the portfolio. If a manager is not prepared to show that kind of information, we would not take it further."
A far more common danger, however, is manager mediocrity, and that can be much harder to spot if a potential investor does not know what to look for.
Shain said that people with backgrounds at established hedge funds who have sustained trading losses in the past and know how to deal with them tend to do better than other would-be hedge fund managers, such as "the person who went to SUNY, worked at Morgan Stanley as an analyst on the mutual fund side, got phased out in 2000 and decided this industry is hot so they should become a hedge fund manager," he said. "I wouldn't want someone to be learning on my nickel."
But even funds of funds managers can be vulnerable to error. Some institutional funds of funds invested in high-profile hedge fund failures Beacon Hill and Lancer Partners. That's why it is important for investors to do their own due diligence on the funds of funds managers themselves. Cerulli's Poor said investors should ask funds of funds managers why the firm thinks it has expertise in selecting managers, what value it adds for investors and how frequently investors can expect to hear about how their investment is doing.