Fees on Fees in Funds of Funds

Abstract

Funds of funds are an increasingly popular avenue for hedge fund investment. Despite the increasing interest in hedge funds as an alternative asset class, the high degree of fund specific risk and the lack of transparency may give fiduciaries pause. In addition, many of the most attractive hedge funds are closed to new investment. Funds of funds resolve these issues by providing investors with diversification across manager styles and professional oversight of fund operations that can provide the necessary degree of due diligence. In addition, many such funds hold shares in hedge funds otherwise closed to new investment allowing smaller investors access to the most sought-after managers. However, the diversification, oversight and access comes at the cost of a multiplication of the fees paid by the investor. It is not generally understood that the incentive fee component of the fee on fee arrangement may under certain circumstances exceed the realized return on the fund. In this paper we argue that the disappointing after fee performance of some fund of funds may be explained by the nature of this fee arrangement. We examine an alternative fee arrangement that may provide better incentives at a lower cost to investors in these funds.