A fund of hedge funds is a type of mutual fund which concentrates its investments on the specific types of investment vehicles known as hedge funds. Like other mutual funds, this fund takes receives capital from multiple sources and invests in several different places to increase diversification. In the case of a fund of hedge funds, the targets for investment are hedge funds, which use aggressive trading strategies to increase returns and minimize risks. Among these aggressive techniques used by hedge funds are derivative trading, selling equities short, currency and interest rate arbitrage, and other methods that are not typically embraced by normal mutual funds.
Investors often want to diversify their portfolios, so that they can become exposed to a broad range of investment securities. Mutual funds are the most common ways to achieve diversification. With just one investment, investors can be exposed to stocks, bonds, commodities, and other securities from across the market landscape. A fund of funds is a mutual fund that only invests in other funds. Taking this concept even further, a fund of hedge funds is a mutual fund that only puts its funds in hedge funds.
To understand how a fund of hedge funds operates, it is first important to understand the basic concept of mutual funds. An investor putting capital in a mutual fund usually makes a minimum opening investment. His or her capital is then managed by a fund manager, while the fund's performance is based on the net asset value of all of the securities it contains. Investors receive a return on investment based on this net asset value, which is distributed to them in the form of capital gains.
Whereas a typical mutual fund might be concentrated on specific types of stocks or bonds, a fund of hedge funds invests only in other hedge funds. Hedge funds are generally reserved for only institutional investors and are open to all types of investment strategies not found in other mutual funds. With these strategies, the funds are able to hedge risk and maximize returns if operated properly.
By investing in a fund of hedge funds, the diversification achieved by investors is multiplied many times over. This is because the investor now has exposure to all of the different securities and strategies found in the different hedge funds that are included. For this reason, pension funds are other collective investments often seek out this type of fund as their investment of choice, since ultimate diversity can be achieved in one fell swoop.