What is a “Feeder Fund”?
Feeder funds are investment vehicles that multiple investors pool their money into, which then feeds into another investment vehicle, known as a master fund. The master-feeder fund structure is popular among hedge funds. This type of fund is exclusively available to wealthy individuals and institutional investors as usually requires a very high initial investment. The two-tier master-feeder structure allows the fund manager to assemble a larger portfolio. Profits are typically distributed in direct proportion to the capital invested by the feeder fund into the master fund.
Key Learning Points
- A feeder fund is an investment portfolio that feeds into another fund, called a master fund
- This two-tier composition is known as the master-feeder fund structure
- The master-feeder structure is very popular with hedge funds, where the investment manager combines a few underlying funds into the master strategy
- Feeder funds would normally require very large initial investments and are therefore marketed mostly to high-net-worth individuals and institutional investors
- Both the master and the feeder fund need to have very similar investment goals in order to be successful
Characteristics of a Feeder Fund
The main purpose of feeder funds is to optimize trading and administrative costs. Normally, all management and performance fees are charged at a feeder fund level. Then, feeding into a larger portfolio (the master fund) would allow the manager to use economies of scale in order to generate larger profits, but less expensively than any of the underlying funds would be able to do. It is essential to note that feeder funds operate as a separate legal entity and are therefore able to feed into more than one master fund (which operate in the same way and may accept more than one feeder fund).
Although different feeder funds that operate under one master fund are likely to have different fees, initial investment requirements, and Net Asset Value (NAV), they need to share similar investment objectives in order to achieve an optimal return. Otherwise, should the feeder fund have unique features that would be lost when combined with the other vehicles? Finally, the return achieved by the master fund is distributed to feeder funds on the basis of percentage contribution to the overall performance.
Overall, the master-feeder structure resembles that of a fund of funds, with the exception that the master fund performs all the investments. Most feeder funds would choose to be set up offshore, in order to receive a pass-through tax treatment and avoid double taxation when sharing the profits from a master fund. However, along with all the advantages that feeder funds bring, investors should be aware that accounting for these vehicles remains complex since they are legally independent entities from the master fund and run their own bookkeeping process. In addition, foreign investors from another feeder fund that is included in the master fund may be restricted from buying particular security. In that case, the master fund would also adhere to these requirements, which may limit its investment universe and potential return.
Below is a multiple-choice question to test your knowledge, download the accompanying excel exercise sheet for a full explanation of the correct answer.