Funds of Funds Could Face Reckoning on Fees

"If you have to get only 1% over cash, the question is, is it worth taking that kind of risk? Should you take your money out of the U.S. government and put it into Citadel?" asks a hedge fund manager, referring to one of the biggest hedge fund shops. Says another: "Their role is useful, but at the core, it comes down to fees."

Funds of funds fees vary, but usually they combine a fixed management levy, often 1% or 1.5%, and a flexible fee based on performance, likely 5%. Let's assume that the fund of funds charges a 1.5%-5% set of fees. When coupled with the 2% management and 20% performance fees usually paid to the underlying hedge fund manager, the investor ends up paying 3.5% of fixed fees and 25% on performance.

"As returns are down, people are questioning fees more and more. There is going to be a downward pressure on fees for funds of funds," says Joel Katzman, the former head of J.P. Morgan Alternative Asset Management, the $9 billion fund of funds arm of J.P. Morgan. One possibility is that fixed fees will go down while performance fees go up.

To be sure, people like the diversification and want to have access to the best managers, Rup says. They also crave the peace of mind created by the shops' due diligence procedures. As a result, whatever threat exists to the business won't be fatal.

"Institutional investors account for more and more of the inflows in the industry, and fund of funds are their vehicle of choice," Katzman says. According to Tremont Capital Management, funds of funds accounted for 17.5% of the hedge fund assets under management in 2002 and 32% last year. It should be 40% this year. Funds and funds are still a thriving business and while their formula is not in jeopardy, the question is, how much will it cost?