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Fund of Funds

A fund of funds is a pooled investment vehicle that invests in other funds rather than directly in stocks, bonds, or other securities. A fund of funds might hold 10–30 hedge funds, private equity funds, or mutual funds, providing diversification across managers and strategies. However, fund of funds incur multiple layers of fees, making them expensive.

This entry covers fund of funds as a wrapper. For the underlying vehicles, see hedge fund, private equity fund, or mutual fund.

How a fund of funds works

A fund of funds manager raises capital and uses it to invest in multiple underlying funds. Here is a typical flow:

  1. Investor contributes $1 million to a hedge fund of funds.
  2. The FoF manager allocates the capital across 15 underlying hedge funds ($66,667 per fund).
  3. Each underlying fund charges a management fee (typically 1.5–2%) and performance fee (20%).
  4. The FoF manager also charges a management fee (1%) and performance fee (10%).
  5. Total fees: The investor pays both the FoF’s fees AND the underlying funds’ fees.

Why fund of funds exist

Fund of funds address several investor needs:

Access. Many hedge funds and private equity funds have high minimum investments ($1 million+) or are closed to new investors. A fund of funds pools many investors to meet minimums and gains access.

Due diligence. Evaluating individual hedge funds requires expertise. A fund of funds manager claims to have this expertise and handles fund selection.

Diversification. Holding 15–20 underlying funds reduces the risk that any single manager underperforms dramatically.

Convenience. One investment instead of 15 separate investments; one tax document instead of 15.

The fee problem

The main criticism of fund of funds is the fee structure. An investor pays:

This creates a serious headwind. A fund of funds holding underlying funds that return 12% gross might deliver:

Underlying return: 12%
Underlying fees: -2% (management) - 2.4% (20% of 12% performance) = -4.4%
Net before FoF fees: 7.6%
FoF fees: -1% (management) - 0.76% (10% of 7.6% performance) = -1.76%
Final investor return: 5.84%

The investor ends up with 5.84% when the underlying funds returned 12%. The fee drag is devastating.

Who benefits from fund of funds

Fund of funds benefit:

  • The fund of funds manager, who charges fees on assets without necessarily adding value.
  • Investors lacking access or expertise, who need the pooling and access benefits enough to accept the fee drag.

Fund of funds do NOT benefit:

  • Cost-conscious investors, for whom the fee drag is unacceptable.
  • Sophisticated investors, who can access hedge funds and private equity directly.

Alternatives to fund of funds

For retail investors, better alternatives exist:

Direct funds. If you have $1 million+, invest in individual hedge funds or private equity funds directly to avoid the FoF fee layer.

Comingled funds. Some alternative investment managers offer pooled vehicles with lower minimums and simpler fee structures.

ETFs and mutual funds. For most retail investors, low-cost broad ETFs and mutual funds provide diversification with much lower fees (0.03%–0.20%).

Multi-asset platforms. Robo-advisors and multi-asset platforms offer diversified portfolios of ETFs and mutual funds at low cost, without the fee layering.

When fund of funds makes sense

Fund of funds are rational only when:

  1. Genuine access problem. You need a fund of funds to access hedge funds or private equity you could not reach otherwise.
  2. Strong manager. The FoF manager has demonstrated skill at selecting and timing underlying funds (rare).
  3. Accepting the fee drag. You understand the cost structure and accept it as the price of access and diversification.

For most retail investors, the fee drag is unjustifiable, and low-cost ETF portfolios are preferable.

See also

Wider context