Funds of Funds Could Face Reckoning on Fees

Still, the industry would be squeezed if fees are forced down too much, predicts Katzman. Large funds of funds have significant expenses. They have teams of analysts specializing on each hedge fund strategy that must scout and monitor the funds, traveling around the world. Big shops also run thorough due diligence that includes detective-like work on hedge fund managers.

"That's why the large funds of funds attract institutional investors," says Katzman. "The big ones have more resources. They may be doing a better job. But if fees go down, profits will be squeezed. They will still be profitable, but the margins won't just be as high as they used to be," he says.

For smaller shops that lack cost scale, expenses can also add up.

A background check, for instance, costs between $3,000 and $5,000 a person. With 50 background checks per year, the annual cost comes out to as much as $250,000. It's not a big deal for a large shop but definitely a problem for a smaller one. "A large number of small funds of funds will be unable to grow and survive unless they partner with a large platform that can inject assets and other resources," says Kevin Pollack, a partner at the New York-based hedge fund merger & acquisition/joint venture specialist Resurrection Advisors.

Meanwhile, hedge funds, especially the large ones, compete directly with funds of funds for institutional money. "Institutional investors are looking at multi-strategy hedge funds vs. funds of funds, so that they don't have to pay the larger fees," says Rup. A manager who runs both a fund of funds and a hedge fund says that he has seen "massive outflows from funds of funds to multi-strategy hedge funds such as those rolled out by Och Ziff Capital Management, Perry Capital and Farallon Capital."