Key Takeaways
- • Hedge fund of funds (FOFs) and hedge fund indexes came under severe scrutiny following 2008 market losses, with industry observers questioning their viability as investment vehicles for institutional capital.
- • FOFs impose multiple layers of fees on top of underlying hedge fund fees, requiring the underlying managers to generate substantial alpha or leverage to match basic buy-and-hold portfolio returns—a structural disadvantage that became acute during market downturns.
- • Yale's David Swensen characterized FOFs as "a cancer on the institutional-investor world," arguing they create a cascade of fees that erodes returns and exclude investors from top-performing hedge fund managers who typically avoid FOF capital.
- • The fee structure mathematics demonstrates the hurdle rate problem: a FOF charging 1% fees and underlying hedge funds charging 2% fees must generate gross returns of 17.75% to match a 10% annual buy-and-hold return, assuming 20% fund leverage.
- • The Madoff scandal illustrated a structural weakness of FOFs as intermediaries, with Swensen noting that fund-of-funds gatekeepers enabled concentrated exposure to fraudulent schemes while collecting additional fees.
Summary
The 2008 financial crisis prompted fundamental questions about the value proposition of hedge fund of funds and hedge fund indexes as investment vehicles. Meb Faber's analysis, published in early 2009 amid the market wreckage, argues that FOFs and hedge fund indexes expose investors to precisely the wrong characteristics of hedge funds while charging excessive fees for the privilege.
The core problem is structural: hedge fund of funds must layer additional management fees (typically 1%) on top of underlying hedge fund fees (typically 2%) and operating expenses. This dual fee structure creates a mathematical hurdle that requires exceptional alpha generation to justify. Faber's calculations show that to achieve the same returns as a straightforward 10% annual buy-and-hold portfolio, a FOF structure requires underlying hedge funds to deliver 17.75% gross returns—a substantial gap that widens during market stress. The leverage required to bridge this gap amplifies downside risk precisely when most needed for portfolio protection.
Yale Investments' David Swensen, quoted in the piece, delivered a particularly scathing assessment of FOFs as investment intermediaries. Swensen characterized them as "a cancer on the institutional-investor world," arguing that FOF structures facilitate uninformed capital allocation while creating perverse outcomes: investors unable to conduct adequate due diligence on individual hedge fund managers are entrusted to FOF managers to conduct even more complex manager selection, all while paying additional fees. Swensen also noted that the best-performing hedge fund managers actively avoid FOF capital due to its unreliability, leaving FOF investors with second-tier managers. The Madoff fraud, he observed, derived much of its capital through FOF intermediaries—a cautionary note about the information asymmetries and conflicts of interest embedded in the FOF model.
The core problem is structural: hedge fund of funds must layer additional management fees (typically 1%) on top of underlying hedge fund fees (typically 2%) and operating expenses. This dual fee structure creates a mathematical hurdle that requires exceptional alpha generation to justify. Faber's calculations show that to achieve the same returns as a straightforward 10% annual buy-and-hold portfolio, a FOF structure requires underlying hedge funds to deliver 17.75% gross returns—a substantial gap that widens during market stress. The leverage required to bridge this gap amplifies downside risk precisely when most needed for portfolio protection.
Yale Investments' David Swensen, quoted in the piece, delivered a particularly scathing assessment of FOFs as investment intermediaries. Swensen characterized them as "a cancer on the institutional-investor world," arguing that FOF structures facilitate uninformed capital allocation while creating perverse outcomes: investors unable to conduct adequate due diligence on individual hedge fund managers are entrusted to FOF managers to conduct even more complex manager selection, all while paying additional fees. Swensen also noted that the best-performing hedge fund managers actively avoid FOF capital due to its unreliability, leaving FOF investors with second-tier managers. The Madoff fraud, he observed, derived much of its capital through FOF intermediaries—a cautionary note about the information asymmetries and conflicts of interest embedded in the FOF model.
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.