Funds of Funds Could Face Reckoning on Fees

For investment advisers who place institutional money with hedge funds, it's been a rough autumn.

So-called "funds of funds" were up just 3.61% in the 10 months to Oct. 31, according to an index compiled by Hedge Fund Research. In October, they returned a negative 1.46%.

While not a terrible performance on a relative basis (the S&P 500 is up 1.67% so far this year), it could prove to be dangerous for a business that charges as much as this one. Funds of funds are said to be "double layered" in their fee structure. That is, they collect money from clients for arranging their portfolios, and pass along the already-stiff management levies assessed by the funds they select.

According to Hedge Fund Research, funds of funds saw $11.6 billion in net inflows through October in 2005, but saw assets decline by $1.2 billion in the third quarter. It was the first quarterly outflow since the group started keeping records on quarters in 2002.

"Some funds of funds have nobody to blame but themselves," says Peter Rup, managing member of Orion Constellation, who manages a fund of hedge funds for the Henry Kaufman Family. "If you can't outperform cash, you can't justify being in business."

Hedge funds face immense pressure to outperform broad market indices every year; those who can't keep up face extinction. The pressure on fund of funds is different. In theory, funds of funds pick the best hedge funds from an estimated 8,000 worldwide managers, using diversification to produce steady returns that remain uncorrelated to major markets. In addition, they sell "capacity," or the ability to invest with star managers whose funds are closed to new investors.

Still, even when returns are adjusted for the safety of diversification, a sub-5% performance won't sit well with sophisticated managers paying two levels of fees.