Funds of hedge funds* type investments are very expensive.
Normally, so expensive that even if all the hedge fund managers in the typical fund of hedge funds were as successful as Warren Buffet was over the last 46 years, investors would still be better off buying a simple index fund.
Let's do the math:
Over the last 46 years**, Warren Buffett as CEO of Berkshire Hathaway has made an average return of 20% per year. Since Mr. Buffett just collected a modest salary almost all of that return went directly to investors.
In hedge fund investments, the fees work very differently:
1. If a hedge fund were successful enough to earn a 20% return, the original hedge fund would typically take fees of about 7% (2% of principal and 20% of profits = 4% + 3.2% = 7.2%) leaving 13%.
2. Then the fund of hedge funds would normally take fees of about 4% (1% of principal and 20% of profits = 1.3% + 2.3% = 3.6%) leaving 9%.
3. Then the distributor may take another 1% and maybe 20% of profits again (1% of principal and 20% of profits = .9% + 1.6% = 2.5%) leaving you with 6.5% before taxes.
4. Assuming you are in the maximum tax bracket, taxes would bring you down to about 4%. Hardly a great return if things go spectacularly well. What if things go badly?
By contrast investing your money in a S&P500 index fund over the same period would have earned you 9.4% per year with only a small tax bite. Simply putting your money in 5 year US Treasury bonds would have earned you 5.4%. And you could get your money out whenever you want.
* How do funds of hedge funds (FOHF) work? The FOHF is normally organized as a partnership. The managers of the FOHF pool investors money to invest in hedge funds they think will make lots of money in the future. They are often sold through brokers or independent investment advisers. The "pitch" is that they can get you access to the world's best investors. The problem is that even if they get almost everything right, the client won't do very well. The high fees turn what could have been a good investment into a poor one.
** Time period reviewed is 1965-2010
Source: Berkshire Hathaway Annual Report 2010