What Is a Fund of Hedge Funds? Fees on Fees

In our worked example, a fund of hedge funds held five funds that together gained 2.00% before any fees. Its investor lost 2.04%. The fees came to $4.04 million on a $2.00 million gain.

A fund of hedge funds charges its own fees on top of the fees of every fund it holds. This guide explains what the structure is for and works through both fee layers on a stated example.

A fund of hedge funds is a hedge fund that puts all or much of its money into other hedge funds. The SEC's 2003 staff report says these funds typically hold 15 to 25 underlying funds.

The investor owns shares of the fund of funds. The fund of funds owns shares of the underlying funds. Each underlying fund charges its own management and performance fees, which hedge fund fees explains.

A multi-manager hedge fund also splits money among many managers, but inside one firm. A fund of funds picks managers who each run a separate fund.

A fund of hedge funds does three jobs. Each bullet names its source, either the 2003 paper "Fees on Fees in Funds of Funds" by Brown, Goetzmann and Liang (NBER Working Paper 9464) or the SEC.

A fund of funds takes on that checking for its investors. The cost is the second layer of fees.

The SEC's 2003 staff report says a fund of funds typically charges a management fee of about 0.5% to 2% of assets. Its performance fee is up to 20% of profit. Both come on top of the fees of the underlying hedge funds.

The example is not a real fund. It holds $100 million, split evenly among five funds, fewer than the 15 to 25 the staff report calls typical, to keep the arithmetic easy to follow. Each fund charges 2% of its starting value plus 20% of any gain left after that fee.

The fund of funds charges 1% of its starting $100 million plus 10% of any profit left after every fee so far. These terms are our assumptions, inside the ranges in the SEC's 2003 staff report.

It is the first year, so no high-water mark applies. A high-water mark is a rule that bars a performance fee until a fund's value passes its earlier peak.

Before fees the five funds return +20%, +10%, 0%, −5% and −15%. Together they gain $2.00 million, or 2.00%.

The funds' performance fees of $1.04 million were paid on the two winners. The portfolio still lost money after those fees.

Total fees were $4.04 million, which is 2.02 times the gain. The same five funds without the top layer would have returned −1.04%.

Source: YX Insights

The five funds gain $2.00 million before fees. Their management fees take $2.00 million, the whole gain. Two funds also pay performance fees of $0.72 million and $0.32 million, so the holdings fall to $98.96 million.

The fund of funds then charges its $1.00 million management fee. Its performance fee is zero because no profit is left. The investor ends with $97.96 million, down 2.04%.

We reran the example with the five funds' average return before fees set anywhere from −10% to +20%. The funds keep the same spread around that average. Their returns sit 18, 8, −2, −7 and −17 points from it.

The two management fees take 3.00 points of assets at every return. At an average of 0%, the investor is at −2.88% after the funds' fees and −3.88% after both layers.

The investor breaks even only when the funds average about 4.2% before fees. At an average of 10% the investor keeps 4.54%. Fees take 5.46 of the 10 points, with 1.50 points from the top layer.

Brown, Goetzmann and Liang used a hedge fund database from a research firm, dated March 2000. Their abstract says individual hedge funds did better than funds of funds on after-fee return.

The chart shows monthly returns after all fees from 1989 to 2000. Funds of funds averaged 0.86% a month against 1.38% for single hedge funds. The medians were 0.79% and 1.05%.

The authors say survivorship may explain part of the gap. Survivorship means that funds which close drop out of reported data, which lifts the average of the funds that remain.

A fund of funds holds a fund until it closes, so its return includes that fund's losses. Closed funds are in the paper's data only from 1994, so some of the lift may remain. The authors still point to fees as one explanation.

They also paired each of 811 hedge funds with a hypothetical fund of funds that held only that fund. In 4,055 fund years (811 funds over five years), there was only one case with no performance fee charged. Funds that lost money before fees lost on average 1.1 points more after those fees.

The data end in 2000. Fees have changed since. The paper is evidence on how the structure works, not a measure of funds of funds today.

Whether hedge funds beat the market is a separate question, which we cover in do hedge funds beat the market.

The 2003 staff report said a registered fund of funds did not have to disclose the fees of the funds it holds. In 2006 the SEC adopted a rule that closed that gap.

The 2006 rule requires a fund of funds registered under the Investment Company Act of 1940 to show "Acquired Fund Fees and Expenses" as a line in its fee table. The line includes the acquired funds' management fees, expenses and performance fees. The requirement still applies in 2026: the current Form N-2, effective 1 July 2024, has the line.

The SEC's 2003 staff report raises three more points.

Form PF is the report that SEC-registered advisers with at least $150 million in private fund assets make to the SEC.

A Qualifying Hedge Fund has net assets of at least $500 million and is advised by a Large Hedge Fund Adviser, a subset of those filers. In the filings for 30 June 2026, 49 Qualifying Hedge Funds in the fund of funds strategy held $65 billion of net assets.

That was about 1.2% of the $5.51 trillion held by all Qualifying Hedge Funds. Other hedge funds are not counted, so the total is below the whole industry.

A fund of funds sells access, diversification and manager selection. It charges for them twice over, because investors also pay every underlying fund.

Brown, Goetzmann and Liang call the performance fees on winners an often overlooked cost of diversification. They are paid fund by fund, so a winner is paid even when the portfolio loses.

This explainer is part of the YX Insights Academy. Each one takes a single idea and checks it against real data.

The same approach runs through everything else we publish:

Good places to start on the website:

A fund of hedge funds is a hedge fund that invests all or much of its money in other hedge funds. The SEC's 2003 staff report says these funds typically hold 15 to 25 underlying funds. Investors own shares of the fund of funds, not of the funds it holds.

The fund of funds charges its own management fee, about 0.5% to 2% of assets in the SEC's 2003 staff report. It adds a performance fee of up to 20% of profit. The underlying hedge funds charge their own fees as well. The investor bears both layers.

The structure offers access to funds closed to smaller investors, diversification across managers and a team that checks the managers. The paper by Brown, Goetzmann and Liang found that these benefits came at a cost. In its data, single hedge funds did better after fees.

No. A multi-manager hedge fund splits capital among portfolio managers inside one firm. A fund of funds holds shares in separate funds run by other firms. Each underlying fund keeps its own fees. Both spread money across many managers, but the structures differ in who runs the underlying portfolios.

DISCLAIMER: This article is strictly educational. Any information or analysis in this note is not an offer to sell or the solicitation of an offer to buy any securities. Nothing in this note is intended to be investment advice and nor should it be relied upon to make investment decisions. Any opinions, analyses, or probabilities expressed in this note are those of the author as of the note's date of publication and are subject to change without notice.