A fund of hedge funds is a pooled investment that buys shares in multiple hedge funds instead of buying stocks or bonds directly

Rather than investing your money in a single hedge fund manager, a fund of hedge funds spreads your investment across ten to fifty different hedge funds. The fund's manager picks which hedge funds to include, handles the paperwork of investing in each one, and collects fees from you for doing so. You own a share of the fund; the fund owns shares in the underlying hedge funds.

This structure exists because hedge funds are difficult to research and expensive to enter individually. A single hedge fund might require a $500,000 or $1 million minimum investment. A fund of hedge funds might accept $25,000 or $50,000 from you, pool that money with other investors' money, and then meet the minimums of multiple hedge funds. You get diversification across managers and strategies without having to write ten separate checks or monitor ten separate accounts.

Key Takeaways

  • A fund of hedge funds charges you a management fee (typically 1 percent per year) on top of the fees charged by each underlying hedge fund (typically 2 percent management plus 20 percent of profits), so your total annual cost is usually between 3 and 4 percent before any gains or losses.
  • The fund manager's job is to select which hedge funds to include and to monitor their performance, but this does not mean the underlying hedge funds will perform well or that your money is protected.
  • You have less direct control over where your money goes than if you invested in a single hedge fund, because the fund of hedge funds manager makes all the selection and replacement decisions.
  • Redemption (getting your money out) can take longer than with a direct hedge fund investment because you must wait for the fund of hedge funds to process your request and then wait for the underlying hedge funds to return capital.

How the fee structure stacks and what you actually pay

A fund of hedge funds charges you two layers of fees. The first layer is the fund's own management fee, usually 1 percent of your investment per year. The second layer is the fees charged by each hedge fund the fund owns shares in, typically 2 percent management fee plus 20 percent of any profits the fund makes.

This creates what is called a "fee on fee" problem. If you invest $100,000 in a fund of hedge funds, you pay roughly $1,000 per year to the fund manager. That same $100,000 is then invested across multiple hedge funds, each of which takes its own cut. If the average underlying hedge fund charges 2 percent management plus 20 percent of profits, your total annual cost before any market movement is between 3 and 4 percent. On a $100,000 investment, that is $3,000 to $4,000 per year just to hold the investment, regardless of whether the fund makes or loses money.

Some funds of hedge funds negotiate lower fees from their underlying hedge funds because they are bringing in large amounts of capital. Others do not. You should ask what the total expense ratio is — the combined cost of all layers — before you invest.

Why someone chooses a fund of hedge funds instead of a single hedge fund

The main reason is access. If you have $50,000 to invest but the hedge funds you want to own require $500,000 minimums, a fund of hedge funds lets you in the door. The fund pools your $50,000 with money from hundreds of other investors and meets those minimums on your behalf.

The second reason is diversification. A single hedge fund manager runs one strategy — say, betting on technology stocks or trading currency pairs. A fund of hedge funds owns managers running different strategies. If one manager's approach stops working, the others may still perform well. This reduces the risk that a single bad decision or market shift wipes out your investment.

The third reason is convenience. Researching and monitoring ten hedge funds requires time and financial knowledge. A fund of hedge funds manager does that work. You receive one statement instead of ten, and the manager is responsible for watching whether each underlying fund is still performing as expected.

What you give up when you use a fund of hedge funds

You pay more in fees. The extra 1 percent management fee on top of the underlying hedge fund fees is real money, and it compounds over time. Over ten years, that extra 1 percent per year can reduce your total return by 10 percent or more, depending on how well the underlying funds perform.

You have less control. You cannot pick individual hedge funds yourself; the fund manager does. If you disagree with one of their choices or want to exit a particular fund, you cannot do so directly. You can only redeem your shares in the fund of hedge funds as a whole.

You face longer redemption timelines. When you want your money back, you submit a redemption request to the fund of hedge funds. The fund then has to request redemptions from its underlying hedge funds. Many hedge funds have lock-up periods (typically one to three years) or redemption restrictions (you can only withdraw on certain dates). This means your money may take weeks or months to return to you, even if the fund of hedge funds itself processes your request quickly.

How to evaluate a fund of hedge funds before investing

Ask for the fund's track record over at least five years, preferably ten. Compare the fund's returns to the S&P 500 or another broad market index. Many funds of hedge funds underperform the market after fees, which means you would have done better putting your money in a low-cost index fund.

Request a full list of the underlying hedge funds the fund owns, along with what percentage of the fund's assets are in each one. A well-diversified fund of hedge funds typically holds fifteen to thirty funds, with no single fund representing more than 5 to 10 percent of the total. If the fund is heavily concentrated in a few managers, you are not getting the diversification benefit.

Ask about the fund manager's experience. How long have they been selecting hedge funds? What is their background? Have they worked through a full market cycle, including a major downturn? A manager who has only worked in a bull market may not know how to protect capital when markets fall.

Get the complete fee schedule in writing. Ask for the total expense ratio, the redemption fee (if any), and any other costs. Do not accept vague answers. If the fund manager cannot or will not give you exact numbers, that is a warning sign.

The difference between a fund of hedge funds and a hedge fund index or ETF

A hedge fund index or exchange-traded fund (ETF) that tracks hedge funds works differently. Instead of a manager hand-picking hedge funds, an index fund holds a large number of hedge funds according to a predetermined formula. This approach typically costs less — often 0.5 to 1 percent per year — because there is no manager making individual decisions.

However, an index approach means you own a slice of many funds, including some that may perform poorly. A traditional fund of hedge funds manager can exclude bad performers and concentrate in the best ones. Whether that active selection actually adds value depends on the manager's skill, and many do not outperform a simple index approach after fees.

Frequently Asked Questions

Can I lose all my money in a fund of hedge funds?

Yes. Hedge funds use leverage (borrowed money) and complex strategies that can amplify losses. A fund of hedge funds does not protect you from this risk; it only spreads the risk across multiple managers. If multiple underlying hedge funds perform poorly in the same market downturn, your investment can decline significantly.

How long does it take to get my money back if I want to withdraw?

It depends on the fund's redemption schedule and the underlying hedge funds' lock-up periods. Some funds allow redemptions quarterly or monthly; others only annually. Once you redeem, the fund of hedge funds must request redemptions from its underlying hedge funds, which can take weeks or months. Plan on at least one to three months from the time you submit your request.

Is a fund of hedge funds better than investing in a single hedge fund?

Not necessarily. A fund of hedge funds offers diversification and lower minimums, but you pay extra fees and have less control. A single hedge fund with a strong manager and a strategy you understand may outperform a fund of hedge funds after fees. The answer depends on your goals, how much capital you have, and your confidence in the fund manager's ability to pick good hedge funds.

What happens if one of the underlying hedge funds fails?

Your loss is limited to the percentage of the fund of hedge funds that was invested in that hedge fund. If the fund of hedge funds had 5 percent in a hedge fund that loses 50 percent, you lose 2.5 percent of your total investment from that event. This is why diversification across many funds matters.