Funds of Funds: Separating the Diligent from the Negligent

by: Susan Mangiero, CFA

According to John Gapper, funds of funds ("FOFs") are significant players, accounting for nearly one-half of all hedge fund assets. This Financial Times chief business commentator connects growing institutional interest to a rise in demand for intermediaries who offer due diligence services. Post-Madoff, he paints a grim picture for the industry unless good players are able to differentiate themselves from those who are now being scrutinized.

Whether certain organizations could have detected fraud is unknown at this time though Grabber suggests that "funds of funds need to work harder and show that they actually contribute something valuable." I am quoted as saying “It is not as if this stuff is really complicated. A lot of the risk of fraud can be mitigated by measures that are low-cost and not very time-intensive.”

I certainly agree with Gapper that there is a "role for the good funds of funds." I'd go further to say that it is unfortunate indeed for those funds of funds that exercised care and discipline in researching financial and operational risks on behalf of pensions, foundations and endowments. They are unfairly being painted with a dirty brush.

For institutional investors, a key question remains. Will pensions, endowments and foundations continue to reach out to funds of funds or decide instead to hire in-house experts? If they have already hired one of the funds of funds that turns out to be tied to large Madoff-related losses, to what extent might investment fiduciaries be asked to explain their FOF choice and subsequent oversight of said FOF? These are important questions, yet to be answered.

Click to read "Funds of funds have to work harder," Financial Times, January 7, 2009. (Access may be limited to subscribers only.)

Author's Note: Click to read "Hedging Your Bets: A Heads Up on Hedge Funds and Funds of Hedge Funds," published by the U.S. Securities and Exchange Commission. Click to read "Report on Funds of Hedge Funds," published by the International Organization of Securities Commissions, June 2008.