In 2006, hedge funds of funds (FOFs) continued to bulk up. Total global assets in these instruments now exceed half a trillion dollars. That's a strong showing, but it's still less than the nearly $1.5 trillion that individual hedge funds hold.

Hedge funds have many admirers and can provide high returns and diversification benefits, along with low correlation to other investment classes. The hedge-fund arena is now flooded with thousands of funds and millions of investors and is becoming increasingly institutionalized. At the same time, funds are moving downmarket in search of investors who previously wouldn't contemplate a hedge fund. FOFs are often the first step investors take into the hedge-fund universe, but their high fees and, in many cases, low returns can make them a questionable investment.

Why a fund of funds?
Hedge FOFs pool investors' money and distribute these assets at their discretion, buying individual hedge funds until they may end up holding 20, 30, or even more funds in their portfolio. FOFs provide the ability to instantly diversify an investor's hedge-fund allocation and the opportunity for investors to reduce the risk of investing with a single manager. What's more, investors with limited capital can access a number of fund returns with one investment. FOFs also offer investors new to the hedge-fund arena the ability to dip their toes into these products and become more familiar with hedge funds before moving on to individual fund investments.

So much to research
With more than 8,000 individual hedge funds to wade through, many investors don't have the expertise or time to research the market effectively, especially considering the fluidity of some funds that blend strategies and constantly move in and out of positions. A FOF can provide investors with professional due diligence and oversight of the hedge funds in its portfolio.

Investor profile
Although hedge funds continue to expand their offerings to appeal to a broader range of individual investors, the profile of hedge-fund investors has been moving from individuals to institutions. Endowments from places such as Harvard University and public pension funds such as Calpers have increasingly invested in this product. In 2006, the SEC took a further step to decrease individuals' roles in hedge funds when it proposed increasing the qualifications for hedge-fund investors. Currently, investors must have a $200,000 income at the individual level or $300,000 in joint spousal income in the two most recent years, along with $1 million in investable assets.

Fee frenzy
Hedge-fund managers typically charge fees of 1% to 2% on an annual basis and can take between 10% and 40% of any capital gains. Some funds even require investors to lock up their money for a couple of years and limit withdrawals to a quarterly basis with long notice periods, such as 100 days. But as they say in the infomercials: Wait, there's more! If you invest in an FOF, then you face a second layer of fees charged at the FOF level, 1% or more on top of what you pay the individual hedge fund, and possibly another performance fee. With such fat fees, it's clear why managers like hedge funds, but unless the returns are high, this can quickly become a loser's game for investors, especially at the FOF level.

Performance for some
Top hedge funds can generate returns of 30% to 40%. SAC Capital Advisors and Atticus Global Fund, for example, both had returns in excess of 30% in 2006. Individual hedge-fund returns, meanwhile, averaged about 14% in 2006 -- not exactly stellar performance, considering an indexed mutual fund would have gotten you around 16%. For FOF investors, the average return of individual funds is important, since these funds are the foundation of FOF investments, and their returns drive FOFs' returns.

As long as you make a nice return, paying a healthy fee is worth it. However, many of the outstanding hedge-fund managers already have enough money, so they can be very selective about who gets into their funds. Those funds taking in new money are mostly startups with new managers, or those with riskier propositions.

Hedge-fund gold rush
During the California Gold Rush in the mid-1800s, many miners saw their financial dreams come true. But thousands never even covered the expense of getting to the gold fields, while some merchants who sold mundane items like picks and shovels made fortunes. Today, there is another gold rush going on in hedge funds, and it might pay to look at some of the service providers rather than the funds themselves. Buy the shares of today's pick-and-shovel hedge-fund merchants, or look at some other options for participation in this market, and you might make out better than if you had bought into a hedge fund.

Goldman Sachs (NYSE:GS) and Bear Stearns (NYSE:BSC) are two companies heavily involved in the hedge-fund arena that could provide investors with exposure to this modern-day gold rush. There are also a number of hedge-like mutual funds that can give investors an opportunity to participate in similar strategies at lower fee levels, along with the additional disclosure that comes with SEC registration. (Hedge funds are not subject to any direct federal regulation.) The Rydex Absolute Return Strategies (RYMSX) fund is one option in this arena. It invests in areas where most mutual funds don't, including currencies, commodities, distressed debt, convertible-bond arbitrage, and merger arbitrage.

Several hedge funds have listed their shares in Europe and give retail investors direct access to this asset class. The London-based hedge fund Marshall Wace went public in late 2006 with its MW Tops Ltd., a Euronext Amsterdam-listed vehicle. MW Tops will invest in a selection of Marshall Wace European TOPS (Trade Optimised Portfolio System) strategies, starting with Opportunistic TOPS and Fundamental TOPS. From inception to the end of October 2006, these two funds have generated annual returns of 23.18% and 20.23%, respectively. In the U.S., New York City-based Fortress Investment Group plans to be the first to market and has registered its initial public offering with the SEC. The firm manages about $9 billion in hedge-fund assets and expects to sell 34.3 million shares at around $16.50 to $18.50. This would be a less expensive way to participate in the hedge-fund boom for those unable or unwilling to plunk down hundreds of thousands (or millions!) on a fund.

Hedge funds for dummies
Investors seem to be throwing money at hedge funds as if they had little regard for fees or manager experience. Richard Breeden, the former head of the SEC, and former U.S. Secretary of State Madeleine Albright, neither one known as a specialist in money-management skills, both started up hedge funds around the turn of the year. Yet investors have placed $500 million and $329 million into the funds, respectively.

Another indication that there's a hedge-fund bubble about to pop is that high-net-worth investors -- the original money source for earlier hedge funds -- now seem to be edging closer to the door. As if that weren't enough, the popular "For Dummies" series published a hedge-fund book in 2006.

Hedge funds of funds can provide investors with many benefits, but they can also be risky and expensive, and they can provide returns much lower than expected. Before joining the gold rush to the hedge-fund arena, carefully consider the fund you are investing in and the rationale for your purchase.

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Fool contributor Zoe Van Schyndel lives in Miami and enjoys the sunshine and variety of the Magic City. She does not own any of the funds or stocks mentioned in this article. The Motley Fool has a disclosure policy.