4 Big Problems with Fund of Funds (Aside from the Obvious)

Nathan Anderson | September 3, 2015

fund of hedge funds cigar burning assetsEveryone knows that a “fund of fees” has to overcome a high bar to justify it’s expenses (typically a 1% management & 10% incentive fee) but here are several other key problems that affect most fund of funds (FoF) investors and every individual investor in hedge funds alike:

4. Position netting.

Take the following example: One of your underlying funds is long Apple and another is short Apple. In this common circumstance it is literally impossible for the FoF to make money, yet management fees will be paid to both underlying funds and the one that got it right will earn performance fees as well!

3. Position herding.

The inverse of the above: if multiple underlying managers are long the same security, the same industry, or even the same geography the fund may be concentrated. Investors expecting muted volatility and diversification may in fact be paying for the opposite.

2. Paying for cash.

Some fund of funds may run high cash balances (20% or more) in an effort to retain dry-powder for potential opportunities. Underlying funds often run high cash balances as well. Investors therefore may be paying double fees to hold 40% cash, which in aggregate can crush net performance.

1. Di-worse-ification.

Managers generally only have a handful of good ideas. If a fund of funds invests across 20 managers, a great idea that’s 10% of an underlying manager’s portfolio may account for less than .5% of the fund of fund’s portfolio. (Add in the effects of cash drag as mentioned above and it becomes incredibly hard for any idea to have a material impact.) In addition, many FoFs are weighed down by fluff; index hedges and low conviction ideas are often included in underlying manager portfolios in an effort to mitigate volatility. When all of these get tossed into the fund of funds pot it dilutes performance and silences the good ideas with a wall of noise.

The Solution.

At the very least fund of funds should be cognizant of position level-detail. Beyond awareness however, separately managed accounts (SMA’s) may allow the FoFs to control cash balances, position levels, and ensure that high conviction ideas actually have a material impact on the aggregate portfolio.

Additionally, investors need to have an understanding of the role the FoF has in their portfolio. Are you paying for smarter beta, or an understanding of an important niche or asset class? Defining your objective will help hone in on the ideal approach.

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Nathan Anderson

Nate co-founded ClaritySpring and oversees the company's strategy and operations.

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