Summary: A hedge fund of funds offers a way for an investor to diversify an amount of money between more than one hedge fund, thus reducing investment risk. Do these funds offer value for money?

Investing in a hedge fund is a costly business.

Upon investment, there is the usual bid/offer spread or dealing charge which will be perhaps 6% or 7% of the total amount invested. In comparison, the mutual fund industry is more likely to cost around 4% upfront.

As you may know, the normal annual management charge for a hedge fund is usually either 2% or 2.5% per year. This compares with fees in the mutual fund industry of between 1% and 1.5% annually. In some low cost funds — index trackers for example — annual costs can be under 1%.

In addition, hedge fund managers make their real money (yes, more!) in their bonus fees. Should their fund grow by more than a preset amount each year (compared to the DJIA, FTSE or a benchmark index), then an override of either 20% or 25% of that growth is paid to the manager.

It must be quite clear that if your little firm has US$1 billion under management, charges 1% more per year than the average and then 25% of any substantial growth on that money, it can be very lucrative. And that means very lucrative to the manager.

This leads us to a fund of funds. Because not only does an investor pay much more than the average to invest in a hedge fund, but they pay a second level of fees to the firm doing the selection of funds.

It is difficult to know just how onerous this selection process really is. Hedge funds use such extreme levels of secrecy that they may not actually tell the fund of funds manager anything! In fact, when combined with their international status and offshore locations, the fund of funds manager may know nothing more than the rest of us.

This does seem to be an expensive way to access alternative investments and — as with funds of funds in general — it may not provide much extra diversification of risk. These fees do seem to be a way to provide an additional drag on annual returns.

He or she may, however, have access to (hopefully legal) privileged information that enables a sound decision to made. In which case, they certainly deserve some form of fee.

This can be a very expensive business for an investor. With such high levels of drag, caused by so many fees, it can be almost impossible to actually make a profit.

It is for this reason that Warren Buffett issued a challenge — an update is here — with a $1 million bet attached to the charity of the winners choice.

Buffett believes that a hedge fund of funds will be unable to beat the S&P. He may well be right. His belief is based in very large part on the impact of all these fees that an investor must pay. They make life so hard for the manager to show a profit that very few could be successful.

It may well be that the best job in the world of investments is to be manager of a fund of funds. After all, there is very little actual investment required themselves. It would appear to be more of a marketing and administration function. Clearly, your author is quite cynical about the actual value that they bring to an investor.

Why such cynicism?

When a fund performs poorly — either because the markets fall substantially or because of poor investment selections — the investor will see the value of his holdings fall in line with the fund and assets. However, if the fund picks up and returns are good, the multiple layers of fees mean that the investor is the last person on the list to actually benefit, meaning that the owner of the assets only sees an increase after fees have been deducted.

Considering the risks being taken, should the investor not benefit first?

This is a discussion that I have had with two people I know. Both live and work in Malta (Europe) and are involved in the administration of MFSA regulated companies. Both firms are hedge fund of funds specialists.

After some long debates, it is clear to me that they both believe in the business and investment model, but so far I am still not wholly convinced myself. Both firms are relatively low profile and certainly not household names. However, both of my friends describe decent and uncorrelated investment returns for professional investors. It seems clear to me that a normal private investor — such as myself, and perhaps you — probably ought not to ever need one of these investment vehicles ourselves.

The pair also display the same habit when I move onto the topic of fees and potential double charging, starting with, Well that is a big and very complicated subject.

A good first investment?

It might not be obvious at first blush, but these types of product can be difficult for a private investor to monitor. Such alternative investments as these are typically not quoted in the Wall Street Journal every day or on CNN or MSNBC because there are so few actual retail investors. And watching the general news about markets such as the Dow Jones or NASDAQ is unlikely to provide any real guide as to how things are performing either.

Obviously, whether a hedge fund of funds is a good idea and investment for you depends upon your personal goals and circumstances. You should always take professional guidance before making any investment decisions. That said, most financial planners or consultants will be unlikely to guide you towards alternative investments such as these since they are far from the mainstream, suitable for a minimum of potential clients and add substantially to the risks being taken.

However, it seems reasonably clear that if one of the most intelligent and successful investors of all time is suspicious of these products, perhaps the rest of us ought to be as well. As they say in investment, caveat emptor. let the buyer beware.

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