Fund of Funds in Hong Kong: Structure, Regulation and Investment Considerations

Introduction to Fund of Funds

A fund of funds ("FoF") is an investment vehicle that allocates its assets across a portfolio of underlying investment funds rather than directly into individual securities or assets. FoF structures have been widely used by institutional investors, family offices, and high-net-worth individuals seeking diversified exposure to multiple fund managers, asset classes, and investment strategies through a single, managed vehicle.

In Hong Kong, FoF structures are used across a range of asset classes, including hedge funds, private equity, venture capital, real estate, and infrastructure. The FoF model provides investors with several potential advantages: access to high-quality underlying managers who may otherwise have high minimum investment thresholds, diversification across managers and strategies, professional manager selection and due diligence, and a simplified investment administrative experience.

This article examines the legal structures, regulatory framework, and key considerations for establishing and operating fund of funds vehicles in Hong Kong.

Types of Fund of Funds

Hedge Fund of Funds

Hedge fund of funds allocate across a portfolio of hedge funds employing different strategies (long/short equity, global macro, event-driven, arbitrage, etc.). The FoF manager's primary value-add is manager selection, portfolio construction, and risk management across the underlying manager portfolio. Hedge FoF were a dominant vehicle type in the 2000s but have faced fee compression pressure, as investors increasingly prefer direct access to top-tier hedge funds.

Private Equity Fund of Funds

PE FoF vehicles allocate commitments across a portfolio of private equity, venture capital, or buyout funds, providing investors with diversified exposure to private markets across vintage years, geographies, and sub-strategies. PE FoF are particularly used by smaller institutional investors who lack the resources to build and manage a direct private markets programme.

Multi-Asset and Real Assets Fund of Funds

Multi-asset FoF structures allocate across a range of asset classes, potentially including liquid (hedge funds, credit) and illiquid (private equity, real estate, infrastructure) strategies. Real assets FoF focus specifically on funds investing in physical assets such as property, infrastructure, commodities, and natural resources.

Legal Structures for FoF in Hong Kong

Open-Ended Fund Company (OFC)

The OFC is a flexible structure for FoF vehicles investing primarily in liquid underlying funds. An OFC FoF can create sub-funds targeting different underlying strategy exposures, providing cost-efficient portfolio construction within a single legal vehicle. SFC-authorised OFC FoF (for retail investor distribution) must comply with the SFC's Code on Unit Trusts and Mutual Funds FoF-specific requirements, including investment concentration limits and disclosure requirements.

Limited Partnership Fund (LPF)

For illiquid FoF (investing in private equity, venture capital, or other closed-ended fund strategies), the LPF structure is commonly used. The LPF FoF makes capital commitments to underlying funds, drawing down LP commitments as the underlying funds make capital calls. The closed-ended nature of the LPF aligns with the illiquid and long-dated profile of the underlying portfolio.

Unit Trust

Unit trusts authorised under the SFC's Code can be used for retail-facing FoF products. The SFC's Code contains specific provisions for FoF, including requirements relating to investment in underlying funds, fee disclosure, and risk diversification.

SFC Regulatory Requirements for FoF

FoF under the SFC Code

SFC-authorised FoF are subject to specific requirements under the Code on Unit Trusts and Mutual Funds, including:

• Investment restrictions: FoF must generally invest at least 70% of their net asset value in underlying funds, which must themselves satisfy prescribed eligibility criteria (e.g., SFC-authorised or authorised by a recognised regulator)
• Underlying fund eligibility: Underlying funds must generally be authorised or registered with a recognised overseas regulator, subject to specified exceptions
• Concentration limits: Investment in a single underlying fund is generally limited to a specified percentage of the FoF's net asset value
• Fee disclosure: FoF must clearly disclose both the FoF-level fees and the fees of the underlying funds, including the aggregate expense ratio
• No double-charging: Subscription and redemption fees should not be charged at both the FoF level and the underlying fund level in a manner that is disadvantageous to investors

Type 9 Licence for FoF Managers

FoF managers managing assets on behalf of third-party investors in Hong Kong require a Type 9 (asset management) licence from the SFC. FoF managers are subject to the same fitness and properness standards, financial resources requirements, and ongoing compliance obligations as direct fund managers.

A key compliance focus for FoF managers is conflicts of interest management, particularly where the FoF manager is affiliated with underlying fund managers. The SFC requires FoF managers to have robust policies for identifying, disclosing, and managing conflicts of interest, and to ensure that investment allocation decisions are made in the best interests of FoF investors.

Due Diligence on Underlying Funds

The investment process for a FoF manager centres on selecting, allocating to, and monitoring underlying fund managers. Due diligence on underlying funds encompasses:

• Quantitative analysis: Performance track record, risk-adjusted returns, volatility, drawdown analysis, and correlation with other portfolio holdings
• Qualitative assessment: Investment philosophy and process, team depth and stability, competitive differentiation, and strategy capacity
• Operational due diligence: Assessment of the underlying manager's operational infrastructure, technology, compliance programme, fund administration arrangements, and custody arrangements
• Legal review: Review of the underlying fund's constitutional and offering documents, investment restrictions, liquidity terms, and key person provisions
• Reference checks: Engagement with the underlying manager's existing investors, prime brokers, auditors, and other counterparties

Operational due diligence has increased in importance following high-profile fund failures attributable to operational failures rather than investment losses. FoF managers are expected to maintain comprehensive ODD programmes and to document their findings for investor reporting purposes.

Fee Structures

FoF investors face a two-layer fee structure: fees at the FoF level and fees at the underlying fund level. FoF-level fees typically include:

• Management fee: 0.5–1% per annum on net assets (lower than single-manager funds, reflecting the FoF manager's manager-selection role rather than direct investment management)
• Performance fee: 5–10% of returns above a specified hurdle (where applicable), compared to the 20% performance fee typical at the underlying fund level

The combined fee burden for FoF investors has been a persistent criticism of the FoF model, particularly during periods of modest overall returns. FoF managers have responded by negotiating fee rebates or discounts from underlying managers, applying performance fees only at the overall portfolio level, and offering fee-only structures without performance fees.

Liquidity Management

Liquidity management is a critical operational concern for open-ended FoF investing in underlying funds with limited redemption windows. FoF managers must carefully align the liquidity terms they offer to their own investors with the liquidity terms of the underlying funds in which they invest, avoiding the liquidity mismatch that contributed to significant FoF failures during the 2008 financial crisis.

The SFC requires authorised FoF to have robust liquidity risk management policies and to disclose liquidity risks to investors clearly. FoF investing in illiquid underlying strategies should generally be structured as closed-ended vehicles to avoid liquidity mismatch.

How Alan Wong LLP Can Assist

Alan Wong LLP advises FoF managers, institutional investors, and family offices on all aspects of fund of funds formation, regulation, and operation in Hong Kong. Our services include FoF structure design and legal documentation, SFC licensing and authorisation applications, investment management agreement negotiation with underlying managers, regulatory compliance advisory, and investor documentation review.

We work with clients across the full spectrum of FoF strategies, from liquid hedge fund portfolios to illiquid private markets allocations, and have deep experience of the SFC's requirements for both authorised and non-authorised FoF vehicles.

Contact us to discuss your fund of funds formation or regulatory needs.