CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

38.9 DISADVANTAGES OF FUNDS OF FUNDS

Double layer of fees: FoF managers effectively pass on to their investors all fees charged by the underlying hedge funds in their portfolios, while also charging an extra set of fees for their own work as well as for an additional layer of service providers. As an illustration, Ang, Rhodes-Kropf, and Zhao (2008) estimate that in the TASS database, the average FoF charges a 1.5% management fee and a 9.2% performance fee on top of the average underlying hedge fund management fee of 1.4% and incentive fee of 18.4% for hedge funds. Due to economies of scale, institutional investors making large allocations have recently been paying much lower fees to funds of funds managers than 1 and 10.

Performance fees on portions of the portfolio: In an FoF, the investor must pay performance fees for each of the underlying hedge funds, regardless of the performance of the overall portfolio. Thus, if half the managers are down 10% and the other half are up 10% on a gross basis, the investor will still have to pay a performance fee to the positive performers despite no positive returns at the aggregate level.

Taxation: Because of their offshore registration, many hedge funds and FoFs may be tax-inefficient for certain investors in certain countries. As an illustration, in Germany, most FoFs invest in hedge funds that fail to meet the extensive notification and disclosure duties requested by the German authorities. As a result, their gains are subjected to heavy ...