Why Do Investors Pay Fund-of-Funds Managers?

by: Felix Salmon

Tim Price isn't impressed with the way that fund-of-funds managers navigated the volatility of the past 12 months:

Hedge funds, often erroneously referred to as an asset class (talent class might be more appropriate, only the phrase smacks of leaden irony given 2008's returns), have disappointed. The CSFB / Tremont Hedge Index, as at end March, was showing year-to-date returns of -2.01% (not bad considering the stock market, but uninspiring given the essential mission to generate absolute returns in all market environments). Whether hedge fund investors are waving or drowning will be almost entirely down to strategy selection. The "traditional" strategies - convertible arbitrage (-7.6%), event driven (-3.3%), equity long/short (-4.1%) - were largely rubbish. A degree of honour was restored by dedicated short bias (+9.8% - every dog has his day), global macro (+6.9%) and managed futures (+10.4%)...

A final aside: "multi-strategy" delivered -3.9% for the quarter. Fund of funds managers will have to work hard at regaining the trust of investors newly sceptical of their ability to locate alpha as opposed merely to creaming off fees.

They'll have some help, it turns out, from Andrew Ang, Matthew Rhodes-Kropf, and Rui Zhao:

We use asset allocation concepts to estimate characteristics of the fund-of-funds benchmark distribution. Since the benchmark characteristics are reasonable, we conclude that funds-of-funds, on average, deserve their fees-on-fees.

I do understand that picking hedge funds is a scary prospect, and that any smart person would want expert help in doing so. But given the amounts of money involved, I don't see why people would want to pay a fixed-percentage management fee rather than a lump-sum consultancy fee. Whatever the hourly rate, it's unlikely to approach 1% or more of total assets.