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 picking individual hedge funds yourself, you invest money into a single fund that does the picking for you. That fund then takes your money and the money from other investors, and uses it to buy into a collection of other hedge funds. You own a piece of the fund of hedge funds, which in turn owns pieces of many different hedge funds.
Think of it like a mutual fund, except instead of holding Apple stock and Microsoft stock, it holds stakes in Hedge Fund A, Hedge Fund B, and Hedge Fund C. The fund of hedge funds manager decides which hedge funds to include, how much money to put into each one, and when to add or remove funds from the collection.
Key Takeaways
- A fund of hedge funds pools investor money to buy into multiple hedge funds, spreading risk across many different strategies and managers.
- You pay two layers of fees: one to the fund of hedge funds manager, and another to each underlying hedge fund, which increases your total cost.
- The main reason to use one is reduced risk through diversification, since losses in one hedge fund may be offset by gains in another.
- Fund of hedge funds are typically only open to institutional investors or very wealthy individuals, not ordinary retail investors.
Why investors use a fund of hedge funds instead of picking hedge funds alone
The primary reason is diversification. If you invested directly in a single hedge fund and that fund made bad bets, you could lose a large portion of your money. A fund of hedge funds spreads your investment across many different hedge funds, each using different strategies. If one fund loses money, the others may gain, cushioning the blow.
A second reason is access. Many individual hedge funds have high minimum investments—sometimes $1 million or more—and long waiting lists. A fund of hedge funds can pool smaller amounts from many investors, making it possible to own a piece of multiple hedge funds without meeting each fund's individual minimum on your own.
A third reason is manager informed. The fund of hedge funds manager is supposed to have skill at picking which hedge funds will perform well. They monitor the underlying funds, remove underperformers, and add promising new ones. This is meant to save you the work of researching hedge funds yourself.
The fee structure: two layers of costs
When you invest in a fund of hedge funds, you pay fees at two levels. First, you pay a fee to the fund of hedge funds manager—typically 1% of your investment per year. Second, you pay the fees charged by each underlying hedge fund you own a piece of—typically 2% per year plus 20% of profits.
This creates what is sometimes called a "fee on a fee" problem. If the underlying hedge funds charge 2% and 20%, and the fund of hedge funds charges 1% and 20%, your total annual cost can easily reach 3% or more before you even earn a profit. These costs are deducted from your returns, so they reduce how much money you actually keep.
Because of these layered fees, a fund of hedge funds needs to outperform what you could earn by investing in the underlying hedge funds directly by enough to justify the extra cost. Many do not, which is why some investors prefer to pick hedge funds themselves if they have the money and time to do so.
How a fund of hedge funds reduces risk
Hedge funds use many different strategies. Some bet that stock prices will fall. Others use leverage to amplify small price movements into larger gains. Some focus on merger arbitrage or currency trading. A fund of hedge funds typically holds 10 to 30 different hedge funds, each with its own strategy.
When strategies are different, they do not all move in the same direction at the same time. If stock prices fall sharply, a hedge fund that bets on falling prices may gain while a hedge fund that bets on rising prices may lose. The gains and losses offset each other, reducing the total swing in your account value. This is the core benefit of diversification.
However, this protection is not absolute. During severe market stress—like the 2008 financial crisis—many different hedge fund strategies can lose money at the same time. Diversification reduces risk but does not eliminate it.
Who can invest in a fund of hedge funds
Most funds of hedge funds are open only to institutional investors such as pension funds, university endowments, and insurance companies. Some are open to high-net-worth individuals, typically those with at least $1 million to $5 million in investable assets.
Ordinary retail investors—people with ordinary bank accounts and brokerage accounts—typically cannot invest in funds of hedge funds. The Securities and Exchange Commission (SEC) restricts hedge fund investments to accredited investors, a legal category that requires either high income or significant net worth.
Some investment firms have created products that mimic the structure of a fund of hedge funds but are open to retail investors. These are sometimes called "hedge fund-like" funds or alternative mutual funds, but they are not true funds of hedge funds and operate under different rules.
The difference between a fund of hedge funds and a hedge fund
A hedge fund invests directly in stocks, bonds, currencies, commodities, and other assets. A fund of hedge funds invests in hedge funds, which themselves invest in those assets. The fund of hedge funds is one layer removed from the actual investments.
Because of this extra layer, a fund of hedge funds has less control over what it actually owns. The underlying hedge fund managers make the day-to-day investment decisions. The fund of hedge funds manager can only choose which hedge funds to include and how much money to put into each one.
A hedge fund also typically has a single manager or small team with a specific strategy. A fund of hedge funds has a manager whose job is to pick other managers, not to execute a particular investment strategy themselves.
When a fund of hedge funds might not be the right choice
If you have enough money to meet the minimum investment of several hedge funds you like, and you have time to research and monitor them, you may be better off investing directly. You would pay only one layer of fees instead of two, and you would have more control over which strategies you own.
If you are a retail investor without millions of dollars, you likely cannot invest in a fund of hedge funds at all. Your options are limited to hedge fund-like mutual funds or other alternative investments that are registered with the SEC.
If you are uncomfortable with the high fees and complexity of hedge fund investing in general, a fund of hedge funds does not solve that problem—it adds another layer of complexity on top. In that case, a traditional diversified portfolio of stocks and bonds may be more suitable.
Frequently Asked Questions
Is a fund of hedge funds safer than investing in a single hedge fund?
It is generally less risky because your money is spread across many different hedge funds and strategies. However, it is not risk-free. During market downturns, multiple hedge funds can lose money at the same time, and you could still experience significant losses.
How much does it cost to invest in a fund of hedge funds?
You typically pay 1% per year to the fund of hedge funds manager, plus the fees of the underlying hedge funds, which average 2% per year plus 20% of profits. Total annual costs often exceed 3% before any gains are counted.
Can I invest in a fund of hedge funds through my regular brokerage account?
Most funds of hedge funds are not available through regular brokerage accounts. You must be an accredited investor, which generally means having high income or significant net worth. Some alternative mutual funds with hedge fund-like strategies are available to retail investors, but these are not true funds of hedge funds.
What happens if one of the underlying hedge funds fails?
You lose the money you had invested in that fund, but the other funds in the portfolio continue operating. Your total loss is limited to the portion of your investment that was in the failed fund, not your entire account.
How often does a fund of hedge funds change which hedge funds it owns?
This varies by manager. Some rebalance quarterly or annually. Others make changes more frequently based on performance. You should review the fund's prospectus or fact sheet to understand how often changes typically occur.