Multistrategy funds-of-funds, like many other hedge funds, are taking advantage of a broad based rally to post their first strong returns of the year. The Hedgefund.net index of 833 funds is up 6.11% this year, with 2.4% of that coming in November alone. However, the sector is unlikely to top last year’s 12.08% return.

Multistrategy funds-of-funds are investment pools that invest in hedge funds in diverse sectors. Unlike hedge funds, funds-of-funds buy or sell nothing, and risk management is performed by investing broadly enough that performance is not correlated to any one strategy or index.

Fund-of-funds managers have a similar fee schedule to hedge fund managers – generally 1% of assets and a 15% to 20% cut of profits. Hedge fund critics – usually from the mutual fund industry – have pointed out that fund-of-funds investors have their return on capital reduced twice.

Because of this, many fund-of-funds investors are larger institutional investors such as insurance companies, pension funds, or endowments that have long time horizons and no need to maximize gains short-term.

The appeal for an investor in a fund-of-funds is both manager selection – hedge funds are not allowed to advertise their performance or directly solicit investment – and diversification. For example, a hedge fund investor seeking to invest in a convertible arbitrage fund would have to sort through the 400 to 500 American convertible managers and obtain audited results, which is difficult because hedge funds are not allowed to advertise and are not required to give information to those not invested in their funds.

Also, hedge fund investors are exposed to the fortunes in a sector – convertible funds are up just 1.42% this year – with out performance difficult to achieve.

A hedge fund-of-funds would probably invest across a variety of equity arbitrage strategies – including risk- and statistical arbitrage – and various bond strategies, such as distressed debt and fixed-income arbitrage strategies. Investing in a fund that allocated equally among the strategies above would have earned approximately 4.44% this year.

However, one of the principal critiques leveled against funds-of-funds over the last several years has been their over allocation to popular sectors, such as stock-picking or macro-funds, that have had sustained runs. Unfortunately, when the bull-market ends in those sectors, many investors rush to redeem their investments simultaneously, forcing the leveraged hedge funds to sell quickly and take losses to get client money back.