Robert Isbitts, president and chief investment officer of Weston, Fla.-based Emerald Asset Advisors, is re-examining his hedge fund investing strategy for his well-to-do clients. The problem? When he included the instruments in his wealthy clients' portfolios, Isbitts had expected the chosen hedge funds of funds to generate 10 percent-plus returns, as they have in years past. But last year, many funds of funds — diversified portfolios of several different hedge funds using different investing strategies — returned less than half of that.

“We're not making dramatic changes to our funds of funds positions for clients until we determine which factors have reduced returns for the last couple of years,” Isbitts says. But if it turns out that funds of funds are not worth the price of admission — or if Isbitts reckons he can create the same noncorrelated returns from picking hedge fund-like mutual funds — “then we'll be taking action,” Isbitts says.

Of course, a one-year return does not a trend make, but last year's prosaic returns are enough for some accredited clients (those with $1 million or more in investable assets) to question whether the fees they are paying to access the hedge fund market — bare minimum of 4 percent a year, on average, and sometimes more — are worth it.

“There is an extra layer of fees in funds of funds, but that is the price of entry,” says Ronald Lake, president of Lake Partners, a Greenwich, Conn.-based consultant that creates funds of funds. “As long as the funds of funds can either provide access, diversification or add value, then the fees are justified.” But on the flipside, Lake says, “If a fund of fund is so overdiversified that its program resembles an index fund or simply turns to mush, that extra layer of fees is going to be hard to justify.”

Any advisor who plans on bringing such vehicles to his well-heeled clients must bluntly discuss the issue with clients, describing the layers of fees — management fees, incentive fees — paid to the underlying fund managers. And don't forget to disclose any fees paid out to you, either. For this reason, accredited retail investors may regard a fund of funds' fee structure as a Russian “nesting” doll: You open the outer doll only to find a smaller one inside — and more are revealed each time you open a doll.

Fees Explained

The first layer of fees is paid to the individual hedge funds in which the funds of funds are investing. Funds of funds are often comprised of as many as 10 funds, and each individual fund is paid a management fee and an incentive fee. The average management fee (the fee the manager receives for general operating expenses) is around 1.47 percent, says research firm Fitzrovia International. The average incentive (or performance) fee is 20 percent, meaning each underlying fund gets to keep 20 percent of any profits it generates.

On top of that, there are management fees for the fund of fund manager itself, which averages in the 1.5 percent range. Further, the fund of fund manager at times will sometimes charge its own type of incentive fee, which can be in the 5 percent to 10 percent range. And if an investor buys into a fund of fund via a financial advisor, he often incurs another fee, generally in the 1 percent range. Some funds of funds offer the 1 percent as a trail over the life of the investment for “account maintenance.”

The end result is even if a fund of fund has a moderate year, fees could eat up a huge chunk of the gains. “In a more robust return environment the layering of fees is less of an issue,” says one fund manager who requested anonymity. “But when funds are struggling to crank out 6 percent to 8 percent returns, about half of that could be taken up in fees.”

Further, incentive fees could slam an investor even if his fund of fund suffered a miserable year. Say a fund of fund invests in three hedge funds, two of which post 20 percent returns, but the third performs so poorly that the overall vehicle loses money. No incentive fee, right? No such luck. The two positive-performing hedge funds will still charge incentive fees, which the losing fund of fund will pass on to its investors. Can it ever happen that an investor is liable for incentive fees when the fund as a whole loses money? Unfortunately, the answer is yes, says a 2004 study of the funds of funds industry co-authored by Steven Brown, a professor at the NYU Stern School of Business; William Goetzmann, with the Yale School of Management; and Bing Liang, with the University of Massachusetts.

Slight Returns

To justify their existence in client portfolios, funds of funds need to post double-digit returns in order to really experience some net (read: after-fee) gains. That, however, is proving to be a tall order of late. “Fees are so hefty that you have to [aim for] returns that are significant: 10 percent to 12 percent plus,” says Rick Cortez, an executive at The Torrey Funds, a New York-based hedge fund of funds.

And 2004 didn't deliver on these promises. The Credit Suisse First Boston Tremont Index reported that hedge funds on average returned 9.64 percent last year, and the Hennessee Hedge Fund Index posted an 8 percent return. By comparison, the Standard & Poor's 500 Index returned 9 percent for the year, and the average stock mutual fund returned 11.96 percent.

“Getting a 3 percent return after fees is a very expensive way to get Treasury note-type returns,” notes one fund manager. And as more institutions — like pension funds and university endowments — enter the funds of funds market, the more downward pressure this creates. There may be too many funds chasing the same strategies, some fear.

Alternatives for Alternatives

However, there are a growing number of alternatives financial advisors can offer clients that offer the core of hedge fund performance without some of the fees that may drive away potential clients. With growing regulation facing the hedge fund industry, some hedge funds are already registering their funds with the SEC (by filling out ADVs) in order to give their products a broader appeal, especially to retail investors.

John Kelly, CEO of hedge fund distributor Man Investments, estimates there are between 75 to 80 such registered funds now, with 25 percent of those funds having completely SEC-registered investments (the remainder still invest in part in nonregistered private placements), which is a fast rate of growth given that the registered hedge fund market started in 2002. For its part, Man currently has about 80 distribution agreements, the “vast majority” of which include its two registered hedge funds, which have been in the market for approximately 15 months, Kelly says.

The growth of registered hedge funds will likely continue. Financial Research Corp. predicted last year that asset flows into registered hedge funds will grow at a compound annual rate of 68 percent until 2009, and that there will be roughly $200 billion in registered hedge funds by 2010, compared with roughly $8.5 billion at the end of last year.

Expect funds of funds to capitalize on this trend. One variant is registered investment companies, “which are essentially hedge funds of funds that have gone through SEC regulatory provisions,” says John Van, chief financial officer at Van Hedge Fund Advisors. These are very investor-friendly funds, with lower minimums and management fees. About 150 are currently operating, Van says.

Further, the “hedge mutual fund” industry is just getting started. Essentially, these funds are mutual funds that use similar hedging strategies as hedge funds, but, because they are officially classed as mutual funds, cannot charge incentive fees. “Other advantages are that mutual funds are subject to more regulatory oversight, do not impose high minimum investments and do not require the investor to be accredited,” says Lake, whose company invests in seven or eight of these type of funds. (See related story on page 72.)

Emerald, the Weston, Fla., advisory, is going further and offering a hybrid index, a fund of funds “using no-load mutual funds that in many cases are similar to what one would find in a hedge fund of funds,” says Emerald's Isbitts. “For instance, the mutual funds would use arbitrage strategies, long/short market-neutral strategies and dedicated short positions. However, instead of delivering it to the client in a limited partnership format, we run separate accounts for them.”

Some advisors, though, are asking funds of funds to change their fee structure. One proposal is to have the funds of funds create one general incentive fee that will be charged only upon the entire fund of funds' achieving a certain performance benchmark. The plan would be that the funds of funds would charge one general incentive fee above market standards (say, 25 percent) in exchange for absorbing all incentive fees on its individual funds.

But this is unlikely. Given the growing popularity and stature of hedge fund managers — even funds of funds managers — there is little chance you could convince them to, in effect, accept a fee cut by such an arrangement. “How do you get access to very smart hedge fund managers? That is where the funds of funds come in handy; you're paying them [the fund of fund manager] another management fee for doing the due diligence,” Cortez says. “But if you treat every money manager the same, then you are narrowing the type of manager that you can hire. Funds of funds are going to pay managers what they think they're worth. If they perform, the clients will stay.”

Another industry expert agreed that the individual underlying hedge fund managers' fee is generally the least negotiable of the layers of fees. “There is a limit on the supply of good managers, so the manager's fee won't come down. It will have to bend on the distribution side.” And that means you.