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FRM Part I · FRM Exam Part I · Fund Management

A fund of hedge funds invests in underlying funds that each charge 2% management and 20% incentive fees. The fund of funds itself charges 1% management and 10% incentive fees on its net profit. In a year when the underlying funds earn a gross 20% on the investment, which feature of this structure is most likely to hurt investors relative to a single hedge fund?

Fees are layered, and each underlying manager collects incentive fees on its own gains without offsetting losses at other funds. So investors can pay substantial incentive fees even when the overall portfolio return is modest, in addition to the fund-of-funds management and incentive fees.

  1. AIncentive fees are paid on each fund's gains even if other funds in the portfolio lose money, so fees can exceed those implied by the net portfolio returnCorrect
  2. BFund of funds cannot diversify across strategies
  3. CManagement fees are charged only once at the fund-of-funds level
  4. DIncentive fees are never paid when the portfolio's overall return is positive

Explanation

Each underlying manager earns incentive fees on its own profits, with no netting against losses at other funds. This asymmetry plus the extra layer of fees reduces investor returns. The other options are incorrect: diversification is a main benefit, fees are layered rather than single, and incentive fees are paid on gains.

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