A feeder fund is a type of investment fund where investors in hedge funds place their money, which in turn feeds into a main fund.
Definition and Examples of a Feeder Fund
A feeder fund is a type of investment fund where investors in hedge funds place their money, which in turn feeds into a main fund. The main fund, not the feeder fund, is what the investment advisor uses for the hedge fund to invest in the market.
For example, we can look at the investment portfolios of BlackRock Investment Management. BlackRock offers two main funds for the financial markets, which are the Treasury Money Market Fund and the Money Market Fund.
Investors will not invest their money directly into those funds. Instead, each of those main funds has a corresponding feeder fund, and the investment results in the feeder fund will directly match the investment results in the main portfolio. The main portfolio and the corresponding feeder fund maintain the same investment goals and strategies.
How Does a Feeder Fund Work?
Feeder funds are a crucial part of the main-feeder fund structure that hedge funds typically use to gather resources from both U.S. and foreign investors.
Investors in hedge funds deposit their initial investments into the feeder funds, and then money flows from these funds into a main fund. The investment manager of the fund uses the money from various feeder funds to invest on behalf of the fund participants.
The investment goals and performance of feeder funds are identical to those of the corresponding main fund, as profits are distributed proportionately to different feeder funds and investors. In this way, investing in a feeder fund can be considered similar to investing in an S&P 500 index fund. When you invest your money in the fund, the index fund itself is not the actual investment; it is merely a vehicle to access it.
Instead, the stocks of all the companies in the S&P 500 are the ultimate destination for your money. The performance of the index fund aims to perfectly match the performance of the index it tracks.
Types of Feeder Funds
In most main-feeder fund structures, there are two types of feeder funds. The first type is a domestic feeder fund for taxable U.S. investors. This fund is typically structured as a limited partnership.
In this type of business relationship, the general partner manages the business operations, while the limited partner does not play an active role in the business operations. Importantly, limited shareholders are only responsible for the amount they invest in the business (or in this case, the fund). In the main-feeder fund structure, the investors in hedge funds are limited partners.
The second type of feeder fund is an offshore fund that invests the money of foreign investors and tax-exempt U.S. investors. The offshore fund is typically structured as a limited company outside the country.
Finally, although the main fund is not a type of feeder fund, it is also important to discuss its structure. In many cases, the main fund is a foreign company. However, in some cases, it may choose to be structured as a U.S. partnership.
Advantages and Disadvantages of Feeder Funds
Advantages
- Lower trading costs: Feeder funds often have lower trading costs because they do not need to break up taxable shares and can manage multiple portfolios to avoid paying fees multiple times.
- Larger pool of investors: The main-feeder fund structure allows the hedge fund to invite a larger group of investors, as they can have separate feeder funds for both taxable U.S. investors and foreign tax-exempt investors.
- Reduced administrative burden: The main-feeder fund structure not only reduces costs but also alleviates the administrative burden. You can have one investment manager or management team overseeing feeder fund investments that otherwise might require a multiplied administrative workload.
Disadvantages
- Available
- For some investors: Feeder funds are often a strategy used by hedge funds, which in the United States are only available to accredited investors. For individuals, you must have an income exceeding $200,000 or a net worth exceeding $1 million.
- Competing investment strategies: Because the master-feeder fund structure often pools investors from different countries, there may be competing investment strategies. For example, tax strategies that work for U.S. investors may not be ideal for foreign investors. Similarly, some assets may be suitable for U.S. investors but not for investors abroad.
- Subject to withholding tax: In the case of an offshore master fund, U.S. earnings are subject to a 30% withholding tax for U.S. investors, with penalties if the fund does not withhold.
What does this mean for individual investors?
As an individual investor, it is unlikely that you will encounter the master-feeder fund structure and feeder funds in your investment journey. As they are a tactic primarily used by hedge funds, they are mainly available to accredited investors in the United States and foreign investors.
However, it is beneficial to understand some of the advanced investment strategies that exist. There may come a day when you qualify as an accredited investor and find yourself investing in a feeder fund. Even if that does not happen, it can be helpful to understand the tactics that institutional investors and high-net-worth individuals use to reduce costs, create efficiencies, and ultimately increase profits.
Source: https://www.thebalancemoney.com/what-is-a-feeder-fund-5204930
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