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FRM Part II · FRM Exam Part II · Hedge Fund Investment Strategies

A fund of hedge funds invests in underlying funds that each charge 1.5% management and 20% incentive fees, and the fund of funds itself charges 1% management and 10% incentive fees. Which statement best describes the main investor concern with this fee structure?

The key concern is the double layer of fees: underlying managers earn incentive fees on winners even when losers offset them, so a flat portfolio can still bear substantial fees, and the fund of funds adds its own management and incentive charges on top.

  1. AIncentive fees are netted across underlying funds at the fund-of-funds level, so losses in one fund offset gains in another before fees are paid
  2. BInvestors pay incentive fees on winning underlying funds even if the overall portfolio is flat, creating a layered fee dragCorrect
  3. CThe fund-of-funds incentive fee eliminates the underlying managers' incentive fees
  4. DLayered fees reduce only the fund's volatility, not its return

Explanation

Underlying managers charge incentive fees on each fund's own gains regardless of losses in other funds, so a flat portfolio can still generate fees, and the fund of funds adds a second layer. The netting option is wrong because netting does not occur across separate underlying funds.

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