How to invest in hedge funds: master-feeder, SMAs, funds of funds
Direct routes include investing in a hedge fund (often through a master-feeder structure), a fund of one, or a separately managed account in the investor's own name. Indirect routes are funds of hedge funds and liquid alternative funds that mimic hedge fund strategies. More control costs more effort; more liquidity means less leverage.
Before this: What a hedge fund is, and how it differs from other funds
On the exam
- Describe investment forms and vehicles used in hedge fund investments
Describe investment forms and vehicles for hedge funds. Expect to match an investor to a vehicle, state the benefits of a master-feeder structure, describe SMA features, and rank vehicles by liquidity.
How deeply to learn each part
- Know the idea
- Understand it in general. It frames other topics, but you will not calculate with it.
- Use it
- Understand it well enough to solve a question with it. Recognize when it applies.
- Memorize
- Learn it by heart. The exam will not give it to you.
You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.
You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.
How is a hedge fund set up?
Most hedge funds are private limited partnerships or limited liability companies, either onshore or in a tax-advantaged offshore location. The legal relationship is that of general partner and limited partners : the manager is the general partner and runs the fund, while the investors are limited partners who put in money and receive a share of returns after fees. The offering documents (the private placement memorandum, the partnership agreement) set out the relationship. A manager may also sign a side letter giving one investor different terms, such as tailored reporting, without changing the fund’s main documents.
A common fee structure is ‘two and twenty’: a 2% management fee and 20% of profits.
What are the direct forms?
- Direct Memorize the investor owns a hedge fund interest or account
- Master-feeder Memorize onshore and offshore feeders into one master fund
- Fund of one Use it a fund built for a single investor
- Separately managed account Memorize assets in the investor's name, manager trades
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- Indirect Memorize exposure through another fund
- Fund of hedge funds Memorize diversified portfolio of hedge funds; extra fees
- Liquid alternatives Use it mutual funds and ETFs that mimic strategies
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In a master-feeder structure , an onshore feeder (for taxable investors in the home country) and an offshore feeder (for foreign and tax-exempt investors) both invest in one master fund, which makes the trades. The manager runs one portfolio, gains economies of scale, can accept money from investors around the world, and handles tax and regulation for each group in its own feeder. A master-feeder does not let taxable investors escape tax. Investing through an offshore fund does not remove a tax liability.
A fund of one is a fund created for a single investor. A separately managed account (SMA) goes one step further: the investor sets up its own account, the assets are held and registered in its name, and the manager is given authority to trade. A prime broker , a bank that lends cash and securities, holds assets and executes trades, supports the account together with a custodian and administrators.
Master-feeder: one portfolio, two doors
Separately managed account: the investor owns it
Fund of funds: diversification, for a second fee
Liquidity spectrum
- ① Economies of scale. Both feeders invest in one master fund, so the manager runs a single portfolio and a single set of trades for investors worldwide.
- ② Tax handling. Each group of investors comes in through the feeder that suits its tax position. Taxable investors still pay their tax; the structure does not remove it.
- ③ The investor owns the assets. In an SMA the account is in the investor's name: full transparency, a custom mandate and negotiated fees, but more operational and governance work.
- ④ An extra fee layer. A fund of funds charges its own fees on top of the underlying funds' fees, in return for diversification across managers, lower minimums and access to funds that may be closed.
Read the diagram as text
Master-feeder structure. US taxable investors invest through an onshore feeder fund, usually a US limited partnership. Non-US investors and US tax-exempt investors invest through an offshore feeder fund. Both feeders put their money into one master fund, which holds a single portfolio and trades through a prime broker. Returns flow back to each feeder and its investors. Callout 1: one portfolio gives economies of scale. Callout 2: each group's taxes are handled in its own feeder; taxable investors still pay tax.
Separately managed account. The investor owns the account and its assets, which are held in the investor's name by a custodian and financed by a prime broker. The hedge fund manager has trading authority under a management agreement with negotiated fees. Callout 3: the investor owns the assets, so it sees every position and sets its own mandate, but takes on more operational work.
Fund of funds. Investors put money into a fund of funds, which charges its own fees of about 1% plus 10% and invests in three hedge funds, each charging about 2% plus 20%. Callout 4: an extra layer of fees, in return for diversification across managers, lower minimums and access.
Liquidity spectrum, from least to most liquid: limited partnerships, separately managed accounts, closed-end funds, mutual funds, exchange-traded funds. More liquid vehicles usually use less leverage and charge lower fees.
An SMA gives a customizable mandate, better transparency, efficient use of capital and enhanced control. It also demands more operational capability and governance, so it suits large institutions. There are downsides. The manager has no personal stake in the account the way it does in a commingled fund, the investor may be offered only the manager’s most liquid trades in return for lower fees, and the manager’s motivation can be weaker. Fees are negotiated, and structuring them to include an incentive fee helps.
What are the indirect forms?
Indirect forms bring hedge fund exposure to smaller institutions and larger individual investors who lack the skills or size to select hedge funds themselves.
A fund of hedge funds pools investor money and invests it across many hedge funds. It offers diversification across strategies, regions and styles, lower minimums, shorter lockups and typically better exit terms than a single fund. Its managers carry out due diligence, monitor performance and can often negotiate better terms. The cost is a second layer of fees: often about 1% more in management fees and a 10% incentive fee on top of what the underlying funds charge. It may also be the only way into a fund closed to new investors. Because it spreads money across many funds, its volatility is generally low, which suits a smaller investor who wants hedge fund exposure at lower risk. In market turmoil, the easier redemptions can weigh on performance when investors withdraw.
Liquid alternatives are mutual funds and exchange-traded funds that use traded securities and quantitative tools to imitate hedge fund styles such as long/short equity, market neutral and event-driven. They offer daily liquidity, lower fees, more regulation and more transparency. In exchange they cannot use leverage as freely, face no redemption limits that would let them wait out a stress, and their returns often fall short of real hedge funds.
How liquid is each vehicle?
The liquidity spectrum ranks the wrappers from least to most liquid.
- 1. Limited partnerships Memorize lockups, gates, notice periods
- 2. Separately managed accounts Memorize direct holdings, negotiated terms
- 3. Closed-end funds Memorize trade on an exchange, often at a discount
- 4. Mutual funds Memorize daily redemption
- 5. Exchange-traded funds Memorize trade all day
Exam tip The more public the wrapper, the more liquid it is and the less leverage it can use.
The strategy can be identical in every wrapper. What changes is control, tax treatment, liquidity and cost.
Go deeper Why SMAs raise operational and governance demands
In an SMA the investor, not the fund, carries the legal and operational load. It must negotiate an investment management agreement, appoint a custodian and prime broker, monitor risk and reconcile trades. A large institution with a dedicated team can do this. A smaller investor usually cannot, which is why it uses a commingled fund or a fund of funds.
Go deeper When a fund of funds' liquidity fails
A fund of funds may offer easier redemptions than the funds it holds. In a stress event, underlying funds can impose gates, and the fund of funds then has to meet redemptions from its cash or by selling its best-valued holdings. It may also have to limit withdrawals itself. Better liquidity terms are therefore not guaranteed when they are needed most.
Memorize this
MemorizeVehicle, features and who it suits
| Vehicle | Key feature | Suits |
|---|---|---|
| Master-feeder | onshore + offshore feeders pool into one master; economies of scale | managers raising money globally |
| Fund of one | fund set up for a single investor | large investors wanting custom terms |
| SMA | assets in investor's name; most control and transparency; negotiated fees | large investors; more operational work |
| Fund of hedge funds | diversified; lower minimums; extra fee layer | smaller investors |
| Liquid alternatives | mutual funds and ETFs; most liquid; less leverage | investors wanting daily liquidity |
Memory hook Liquidity rises as the wrapper gets more public: LP, SMA, closed-end fund, mutual fund, ETF.
Know it cold A master-feeder does not let taxable investors avoid tax. Funds of funds typically add about 1% plus 10% on top of the underlying fees.
- Direct Memorize the investor owns a hedge fund interest or account
- Master-feeder Memorize onshore and offshore feeders into one master fund
- Fund of one Use it a fund built for a single investor
- Separately managed account Memorize assets in the investor's name, manager trades
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- Indirect Memorize exposure through another fund
- Fund of hedge funds Memorize diversified portfolio of hedge funds; extra fees
- Liquid alternatives Use it mutual funds and ETFs that mimic strategies
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- 1. Limited partnerships Memorize lockups, gates, notice periods
- 2. Separately managed accounts Memorize direct holdings, negotiated terms
- 3. Closed-end funds Memorize trade on an exchange, often at a discount
- 4. Mutual funds Memorize daily redemption
- 5. Exchange-traded funds Memorize trade all day
How it is asked
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Match the investor to the vehicle
A family wants its own mandate, full transparency and assets held in its name.
Separately managed account. Trap: fund of funds.
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Master-feeder benefit
A key benefit of a master-feeder structure is...
Pooling onshore and offshore investors in one portfolio for economies of scale. Trap: eliminating taxes.
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Rank by liquidity
Which vehicle is most liquid for hedge-fund-like exposure?
ETF. Order: LP, SMA, closed-end, mutual fund, ETF.
Exam traps
- Saying SMAs have simpler fees than mutual funds. SMA fees are negotiated account by account.
- Saying a master-feeder lets taxable investors avoid tax. It pools onshore and offshore investors; each investor is still taxed as the law requires.
- Ranking SMAs as more liquid than ETFs.
- Forgetting that a fund of funds adds a second layer of fees.
Checkpoint
7 exam-style questions. About 90 seconds each.
1A wealthy family wants a hedge fund strategy with its own mandate, full transparency and the assets held in its name. The most appropriate vehicle is a:
2A manager in London sets up a domestic feeder for taxable investors and a second feeder for foreign and tax-exempt clients, both investing in one master fund. The main benefit of this setup is most likely that:
3Which vehicle offers the most liquidity for hedge-fund-like exposure?
4Compared with investing directly in a single hedge fund, a fund of hedge funds is most likely to offer:
5Which statement about separately managed accounts (SMAs) is least accurate?
6In a master-feeder structure, the offshore feeder fund is most likely designed for:
7Compared with a hedge fund, a liquid alternative ETF that replicates hedge fund styles is most likely to have:
Key takeaways
- Direct forms: master-feeder, fund of one, separately managed account. Indirect forms: funds of hedge funds and liquid alternatives.
- A master-feeder pools onshore and offshore investors into one master fund for scale.
- SMAs give control, transparency and custom terms, at the cost of operational work.
- Funds of funds diversify and cut minimums but add a second fee layer.
- Liquidity rises from limited partnerships to SMAs, closed-end funds, mutual funds and ETFs.
Questions about this lesson?
Where this comes back
- Hedge fund returns: market beta, strategy beta, alpha and diversification Hedge Funds
- Fund of funds fees, survivorship bias and backfill bias Alternative Investment Performance and Returns
Questions candidates ask
What is a master-feeder hedge fund structure?
An onshore feeder fund and an offshore feeder fund both invest in one master fund that makes the trades. It lets the manager run a single portfolio for taxable, foreign and tax-exempt investors, with economies of scale. It does not let taxable investors avoid tax.
What is a separately managed account?
An account in the investor's own name, managed by the hedge fund manager under an investment management agreement. The investor gets customization, transparency and control, with negotiated fees, but takes on more operational and governance work.
Why invest in a fund of hedge funds?
It gives diversified hedge fund exposure with lower minimums, professional due diligence and sometimes better liquidity or access to closed funds. The cost is an extra layer of fees, often about 1% plus a 10% incentive fee.
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