So What's A Poor Investor To Do?
Like it or not, many capital preservation-oriented investors will find that the best solution is to employ hedge funds of funds as the core of their hedge fund portfolio strategy, perhaps adding a few individual funds as "satellites." That brings us to the (dare I say "knee-jerk"?) reaction of many investors: "I hate funds of funds!"

It's not wrong to be skeptical. Of the roughly 1,000 funds of funds in existence, no more than 75 will be worth looking at. Just like most individual hedge funds, most of the fund groups don't justify their fees.

People tend to have two main concerns about funds of funds. The first is that the funds tend to underperform individual hedge portfolios. True enough. The HFR Fund of Hedge Fund Index typically underperforms the HFR Weighted Hedge Fund Index over longer periods of time. But it's also true that most active long-only managers underperform their benchmarks. Yet most people still prefer active management.

So let's look closely at what we are saying here. We are saying that we can pick individual hedge fund managers who will outperform, but that if we go with funds of funds we will pick one that underperforms. It's got to be one way or the other, folks-either we can pick outperforming funds or we can't. And if we pick lousy individual hedge funds we face blowup risk, while at least with lousy funds of funds we diversify that risk away.

Investors also hate the extra layer of fees that funds of funds charge.  But they don't charge this extra layer simply because they are greedy. They charge it because that's what it costs to do what needs to be done to build a soundly performing hedge fund portfolio.

Investing in hedge funds is a devilishly difficult business, and a good hedge fund of funds offers the same skill set any investor would need to build a successful portfolio of individual hedge funds:
Portfolio management
Strategy allocation decisions
Return and risk expectations and analysis
Liquidity analysis and capacity determination
Manager research
Identification, evaluation and sourcing of new managers
The ongoing monitoring of managers and relationship management
Structural risk analysis
Identification and monitoring of non-investment and operational risks
What would we have to pay for these skills if we had to build our own staff? Believe me, you don't want to know.

But What About Multi-strats?
Some multiple-strategy funds are among the best hedge funds in the business. But there are three issues that should give anyone pause-that is, anyone who imagines that he or she can build a bulletproof portfolio by using only multi-strats.
First, few of them are worth looking at. A multi-strategy hedge fund isn't really an investor-focused product, but a hedge fund manager-focused product. Most multi-strats started out life as convertible arbitrage hedge funds. The trouble with convert arb, if you are the manager, is that sometimes it's a productive strategy and sometimes it isn't. When it isn't, your investors leave and your staff resigns. What to do? You can build into your fund some other strategies, preferably ones that tend to be productive when convert arb isn't! It's brilliant! (Never mind that this manager doesn't know anything about any of these other strategies.)

Second, multi-strats tend to provide diversified exposure to multiple strategies when investors need it least (i.e., when most strategies are doing well) and fail to provide strategy diversification when investors need it most: when everyone gets enthusiastic about one or two strategies that turn out to be bogus.

Finally, and most important for our purposes here, remember that when we are at the point of structuring our hedge portfolio we aren't yet terribly concerned about strategy diversification. What we are concerned about is organizational diversification, meaning the possibility that any of our individual hedge funds, multi-strat or otherwise, might explode. As we know all too well (with Long Term Capital Management and Amaranth), multi-strats also do it.

A Brief Summary Of Sound Hedge Fund Strategies
Investing in individual hedge funds. This is the most common strategy and the most dangerous. It's to be avoided except by the extremely wealthy.