Fund of Funds
A fund of funds (FoF) is an investment vehicle that allocates capital across a portfolio of underlying hedge funds or private equity funds rather than investing directly in individual securities.
Fund of funds structures exist primarily to provide diversification across managers, strategies, and vintage years within the alternatives space. By spreading capital across ten to thirty underlying funds, an FoF reduces the risk that any single manager's blow-up destroys the portfolio. This is particularly valuable in hedge funds, where strategy concentration and manager-specific risk can be severe.
The main disadvantage is the double layer of fees. Investors pay the FoF manager a management fee and sometimes a performance fee on top of the fees charged by each underlying fund. In a traditional hedge fund FoF, an investor might pay 1% management and 10% performance to the FoF, plus 2% management and 20% performance to each underlying fund — a substantial total cost drag. For the FoF to justify its fees, it must either provide access to closed or capacity-constrained funds or deliver superior manager selection that consistently identifies top-quartile returns.
In private equity, FoF structures offer smaller LPs access to flagship buyout and venture funds that have high minimum commitments. A pension fund with only a small alternatives allocation might not meet the $10 million or $25 million minimums of premier PE funds, but it can access the same managers through a FoF that aggregates commitments from many smaller investors.
Due diligence is the core competency of an FoF manager. Evaluating underlying fund managers requires assessing track records, operational infrastructure, risk management practices, legal terms, and team stability — a resource-intensive process that smaller institutional investors may lack the staff to perform themselves. The FoF fee is partially a payment for that capability.