Key Takeaways
- • Hedge fund of funds (FOFs) and hedge fund indexes create structural fee drag that requires underlying managers to generate substantial alpha or leverage to match basic buy-and-hold returns. A FOF investor seeking 10% annual returns faces compounded fee erosion—gross hedge fund returns must reach 17.75% to net the equivalent of a 10% buy-and-hold strategy after multiple layers of fees.
- • Yale CIO David Swensen characterizes FOFs as "a cancer on the institutional-investor world," arguing they enable capital allocation by unsophisticated investors while excluding access to top-performing managers. Best-performing hedge funds actively avoid FOF capital due to its perceived unreliability and the added layer of intermediation.
- • The fee structure of FOFs creates a mathematical disadvantage: investors pay advisory fees to FOF managers in addition to underlying hedge fund fees, reducing net returns below what direct hedge fund or passive index exposure would deliver.
- • 2008 marked a critical inflection point for the FOF business model, raising questions about the viability of multi-layered fee structures during market stress when alpha generation becomes difficult and leverage-dependent strategies face redemption pressures.
- • Swensen links FOF intermediaries to the Madoff scandal, noting that fund-of-funds structures facilitated capital concentration in fraudulent strategies by obscuring due diligence responsibility across fee-capturing layers.
Summary
The viability of hedge fund of funds and hedge fund indexes came under intense scrutiny in 2009 as practitioners confronted the structural inefficiencies exposed by the prior year's market collapse. Meb Faber's analysis challenges the fundamental value proposition of FOFs and hedge fund indexes, focusing on their inherent fee burden and misalignment with investor return objectives.
The mathematics of FOF returns illustrate the core problem. When a baseline buy-and-hold portfolio targets 10% annual returns, a hedge fund of funds charging typical fees must generate 12.22% in gross returns to deliver equivalent net performance after the FOF layer. The underlying hedge fund itself must then generate 17.75% gross returns to account for both the FOF fees and its own management and performance fees (assuming 20% performance fee). This calculus means that FOF investors gain exposure primarily to the components of hedge funds they should avoid—beta exposure and leverage—rather than genuine alpha generation.
David Swensen, Yale University's chief investment officer, provides the most caustic institutional critique of FOFs. In a Wall Street Journal interview cited in the analysis, Swensen describes FOFs as "a cancer on the institutional-investor world" that "facilitate the flow of ignorant capital." His argument presents a logical chain: if an investor cannot intelligently select hedge fund managers directly, how can they competently select a FOF manager to make those selections on their behalf? The multilayered fee structure compounds this problem, he argues, while simultaneously disqualifying investors from access to the highest-performing managers—which Swensen estimates comprise only the top 10% of the hedge fund universe. Top-tier managers actively avoid FOF capital structures because such capital is viewed as unreliable and operationally burdensome.
Swensen further connects FOF intermediaries to the Bernard Madoff fraud, noting that fund-of-funds structures "facilitated the flow" of capital into the scheme and that Madoff "wouldn't have had nearly as much resources were it not for fund of funds." The observation highlights how FOF structures obscure manager scrutiny across multiple fee-capturing intermediaries, creating systemic vulnerability to fraud.
The 2008 financial crisis provided a stress test for these critiques. When markets contracted and leverage-dependent strategies faced margin calls and redemptions, FOF investors confronted the reality that multiple fee layers do not disappear during downturns, while alpha generation becomes elusive. This context suggests that 2008 may mark a structural turning point in how institutional capital evaluates the cost-benefit calculus of fund-of-funds intermediation.
The mathematics of FOF returns illustrate the core problem. When a baseline buy-and-hold portfolio targets 10% annual returns, a hedge fund of funds charging typical fees must generate 12.22% in gross returns to deliver equivalent net performance after the FOF layer. The underlying hedge fund itself must then generate 17.75% gross returns to account for both the FOF fees and its own management and performance fees (assuming 20% performance fee). This calculus means that FOF investors gain exposure primarily to the components of hedge funds they should avoid—beta exposure and leverage—rather than genuine alpha generation.
David Swensen, Yale University's chief investment officer, provides the most caustic institutional critique of FOFs. In a Wall Street Journal interview cited in the analysis, Swensen describes FOFs as "a cancer on the institutional-investor world" that "facilitate the flow of ignorant capital." His argument presents a logical chain: if an investor cannot intelligently select hedge fund managers directly, how can they competently select a FOF manager to make those selections on their behalf? The multilayered fee structure compounds this problem, he argues, while simultaneously disqualifying investors from access to the highest-performing managers—which Swensen estimates comprise only the top 10% of the hedge fund universe. Top-tier managers actively avoid FOF capital structures because such capital is viewed as unreliable and operationally burdensome.
Swensen further connects FOF intermediaries to the Bernard Madoff fraud, noting that fund-of-funds structures "facilitated the flow" of capital into the scheme and that Madoff "wouldn't have had nearly as much resources were it not for fund of funds." The observation highlights how FOF structures obscure manager scrutiny across multiple fee-capturing intermediaries, creating systemic vulnerability to fraud.
The 2008 financial crisis provided a stress test for these critiques. When markets contracted and leverage-dependent strategies faced margin calls and redemptions, FOF investors confronted the reality that multiple fee layers do not disappear during downturns, while alpha generation becomes elusive. This context suggests that 2008 may mark a structural turning point in how institutional capital evaluates the cost-benefit calculus of fund-of-funds intermediation.
Go deeper than the headline
Research every firm in this story, track the ones that matter and get the daily briefing — free for 7 days.