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.

"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?

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."

In addition, hedge funds are becoming increasingly less liquid, forcing investors to keep their money in for a longer period of time. As a result, funds of funds have fewer choices if liquidity is a consideration. According to the Wall Street Journal, many big hedge funds, including Kingdom Capital Management, Citadel Investment Group and Eton Park, are in the process of imposing or have instituted longer lock-up terms, a ploy to avoid registration with the Securities and Exchange Commission.

While funds of funds are still the favorite way for institutions to consider a foray into hedge funds, as investors evolve and become more sophisticated, expenses will become a bigger issue. As other areas of Wall Street have shown, middlemen receiving big commissions for a service that can be readily duplicated rarely last forever.

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