Explain how funds of funds are structured and how their fees stack up
The idea
A fund of funds allocates across a set of underlying managers, offering diversification, access to closed funds and a diligence capability the investor may lack. It charges its own management and incentive fee on top of those of the underlying funds, so the investor pays two layers. The layering is worse than it looks in a mixed year: incentive fees are owed to each winning underlying manager regardless of what the losers did, so an investor can pay substantial performance fees on a flat or negative net return.
A practice question
What is the main cost disadvantage of a fund of funds?
- The investor pays fees at both levels — correct
- Underlying funds charge no management feeWhy not: They charge their full fees, which is exactly why the second layer is the problem.
- It cannot access closed fundsWhy not: Access to capacity-constrained managers is one of the structure's advantages.
Fees apply at the fund-of-funds level and again at the underlying fund level. Two layers of management and incentive fees on the same capital is a high hurdle for the diversification and access benefits to overcome.
A harder one
Why can an investor in a fund of funds pay significant incentive fees in a flat year?
- Because the fund-of-funds fee is charged on gross assetsWhy not: The management fee is, and the incentive fees in question are owed at the level below.
- Because each profitable manager is owed a fee — correct
- Because high-water marks do not apply to funds of fundsWhy not: They apply at both levels. The issue is that they apply manager by manager rather than across the portfolio.
Fees are owed manager by manager regardless of losses elsewhere. Performance fees are computed fund by fund, so gains at some managers generate fees while losses at others simply reduce the investor's return.
The hardest tier
For which investor is a fund of funds most defensible despite the fee layering?
- A large institution with a dedicated hedge fund research teamWhy not: Already has the capability the second fee layer is paying for.
- An investor seeking the lowest possible costWhy not: The structure is among the most expensive available; cost minimisation points elsewhere.
- A smaller investor lacking the scale and staff to diversify across managers and conduct diligence — correct
The second layer buys manager selection, monitoring and access that the investor cannot otherwise obtain. Where those capabilities already exist in-house, the layer is pure cost.
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