The hidden trap in Fund of Funds strategies: Structural risks

What are Fund of Funds strategies?

Fund of Funds (FoF) strategies have long been regarded as an attractive option for investors seeking diversified exposure and access to specialized managers. By investing in a portfolio of various investment funds rather than individual securities, FoF investments offer a kind of 'one-stop-shop' for diversification. This approach has attracted a wide range of investors—from individual private investors (including high-net-worth individuals or so-called “HNWIs”) to large institutional players.

However, a significant challenge often overlooked with these strategies is structural risk. This risk arises when insufficient due diligence is performed on the underlying fund structures, potentially leading to an inadequate understanding of the overall risk exposure of one's investment. Fund brokers, managers, and investment advisors (referred to as “Asset Managers”) may be inclined to only evaluate the top layer of the FoF structure, meaning that the deeper layers are not thoroughly examined. This could involve the specific strategies, fee structures, credit ratings, risk and liquidity profiles, and operational practices of the underlying funds or investments.

Given the ever-increasing complexity and innovation within financial products, it has become more critical than ever for Asset Managers to equip themselves with the necessary knowledge and tools to navigate these layered investment structures effectively.

What are structural risks?

Layered risk, also known as underlying structural risk, is a particular form of investment risk that is especially prevalent in FoF strategies. This risk arises from factors such as lack of transparency, increased complexity, and thus understanding of the underlying layers of investments that a FoF contains.

On the surface, a FoF structure might seem to offer diversification and access to a wide range of investment opportunities through a single investment entity. However, beneath the surface often lies a complex cascade of different funds, each with its unique characteristics and structure.

A key cause of layered risk is that Asset Managers may tend to focus solely on analyzing and performing due diligence on the top layer of the FoF structure—the FoF itself. This approach overlooks the deeper layers, which are the individual funds in which the FoF invests. Without a thorough analysis of the underlying funds and investments, Asset Managers risk exposing investors to hidden risks that could have impacted their investment decisions. These risks may include:

• Concentration risk, where multiple funds invest in the same assets, geographies, or sectors.
• Operational risks related to the management of the underlying funds, including reporting.
• Additional costs accumulating at each layer, thereby reducing the overall return.
• Use of leverage in the underlying funds, which can amplify both gains and losses, thus increasing risk.
• Differences in liquidity profiles of the underlying funds, including redemption access. Some of these are elaborated on below.

Potential consequences of structural risks

Structural risks can lead to a range of unexpected challenges that may potentially undermine the anticipated benefits of diversification that FoF strategies aim for. A major challenge with layered risk is assessing the actual and total risk exposure.

In a FoF structure, risk assessment becomes more complex as it requires understanding not only the risks at each layer but also how these risks interact across the entire investment structure. For instance, a risk that appears minimal in the initial layer might be amplified when combined with risks from other layers, leading to a higher total risk exposure than initially assumed.

The structural risk in investments, particularly within complex fund structures like FoFs, can have profound consequences for investors. This is primarily because a superficial analysis of the top investment layers often overlooks the deeper, more intricate risks lying in the underlying layers.

A primary consequence of this lack of insight is exposure to unforeseen legal and compliance-related risk factors. If the underlying funds operate under different jurisdictions, regulatory frameworks, or have complex structural arrangements, investors might inadvertently face legal risks ranging from regulatory breaches to contractual ambiguities. These risks are often hidden and can result in significant legal costs or losses.

Another critical consequence is operational risk. Lack of transparency in the operations of the underlying funds can conceal inefficiencies or internal control weaknesses. This may lead to operational errors, fraud, or mismanagement, directly affecting the fund's performance and safety.

Additionally, liquidity risk can be a significant concern. The liquidity constraints of the underlying funds can impact the investor's ability to realize values, particularly in crisis situations. Without a deep understanding of these constraints, investors may find themselves trapped in illiquid positions with no option for early or even timely exit.

Finally, there is the risk of reduced diversification. While an overarching fund structure might seem to offer diversification, the underlying funds might have overlapping investments, which increases concentration risk. Without thorough analysis of each fund component, a seemingly diversified portfolio may, in reality, be more risky and less resilient to market volatility.

These consequences of structural risk in investment strategies highlight the importance of Asset Managers conducting in-depth due diligence. It is crucial to understand all layers of the investment to ensure appropriate risk management and align investments with their risk tolerance and objectives.

Disclaimers as part of the solution

To address layered risk effectively, it is essential to not only consider historical returns and fees but also to understand the investment strategies, liquidity, and risk management practices of the underlying funds and the overall portfolio construction. Only through a comprehensive approach can the true risks of investing in a FoF structure be uncovered and managed effectively.

In the context of investment advisory and portfolio management, extensive due diligence processes can be both time-consuming and costly, often performed by lawyers, financial advisors, and other professionals with specific expertise in fund structures. This is especially true for smaller fund management firms or situations with limited resources. A potential solution to this issue is to supplement or partially replace in-depth due diligence with well-structured and legally robust disclaimers. These disclaimers can be crafted to inform and warn investors about specific risks, including those related to the lack of in-depth due diligence on underlying investment structures.

It is essential to understand that the use of disclaimers does not completely eliminate the need for due diligence or the obligation to act in the best interest of investors. Rather, they can serve as a risk alert to investors, who can then make a well-informed and considered investment decision. Such an approach may involve clear communication that certain aspects of the investments have not been thoroughly examined, and that the investments therefore carry some unresolved risks. Disclaimers should clearly state that investors are responsible for further due diligence and are advised to seek independent advice.

Moreover, it is crucial to note that the use of disclaimers does not absolve the fund management company from its fundamental obligations and responsibilities to investors. The company must still comply with applicable laws and regulations, including the requirement to act in the client's best interest and avoid conflicts of interest. Disclaimers should therefore be crafted carefully and precisely to ensure they comply with legal and ethical standards and are not misleading or opaque to investors.

In summary, cost-effective solutions such as using disclaimers can be a practical approach for smaller fund management firms, but it is crucial to balance this approach with the necessity of maintaining high standards for investor protection and regulatory compliance.

Questions?

If you have any questions or need further information about FoF strategies and structural risks, please feel free to contact partner Kim Høibye, associate partner Jakub Zakrzewski, and assistant attorney Honas Kader.