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

A pension plan is comparing a direct allocation to a single hedge fund with an allocation to a fund of funds (FoF). Which of the following is the most commonly cited drawback of the FoF structure relative to direct investment?

The main drawback of a fund of funds is the double layer of fees: the FoF charges its own fees on top of those paid to underlying hedge fund managers. Diversification and delegated due diligence are advantages, and the structure does not require underlying funds to hold liquid assets.

  1. AIt cannot diversify across strategies or managers
  2. BIt adds a second layer of fees on top of the underlying managers' feesCorrect
  3. CIt removes the ability to use manager due diligence
  4. DIt forces all underlying funds to hold only liquid assets

Explanation

A FoF charges its own management and often incentive fees in addition to the fees of the underlying hedge funds, creating a double layer of fees. Diversification and delegated due diligence are benefits, not drawbacks. FoFs do not force underlying funds to hold liquid assets.

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