Will Madoff End The "Fund of Funds" Racket? Unlikely

One of the greatest games in the investment business in recent years has been the fund of funds. FOFs don't actually manage client money themselves--they just give it to other people to manage. And, of course, they charge huge fees in the process.

Funds of funds extoll the extraordinary research they do to identify only the best managers for their clients, and they detail the impressive statistical and qualitative analyses they use to do it. The Bernie Madoff scandal has illustrated that, at some fund of funds, this due diligence is either fiction or meaningless. But even when funds of funds don't get fooled by the likes of Madoff, they're usually a lousy deal. Why? Because their fees eat up any "alpha" that is left over after the hedge funds they invest in take their own (humongous) cut.

Earlier, we wrote about why hedge funds are the best business in the world (because managers get paid enormous "performance" fees even if their performance is average, and they take no downside risk). It's possible, however, that the fund of funds business is actually the best business in the world. The average fund of funds doesn't have to do half the work that the average hedge fund does.

As with hedge funds, about 1-in-10 fund-of-funds firms probably earn their fees. The rest either slowly drain value away (especially after tax) or are accidents waiting to happen. The challenge for investors is to figure out which fund of funds firms actually add value from the great majority that destroy it. And this is a heck of a lot easier said than done.

In our hedge fund post, we ran numbers on a hypothetical hedge fund called Capital Compensation Partners that made a killing over the past several years while its investors got killed. Today, we've updated these numbers for a hypothetical fund of funds called--what else?--Capital Compensation Group. The only difference between this five-year performance and the performance of the hedge fund is an additional layer of fees: Capital Compensation Group charges 1% and 10% on top of the underlying hedge fund fees.

To review, in our hypothetical hedge fund example, Capital Compensation Partners, LLC raised a $1 billion fund at the end of 2002 with a typical 2/20 fee structure. The fund manager invested the entire fund in an S&P 500 ETF on Jan 1, 2003, and posted nice-looking gross results over the next five years...until, in year Six (this year), the performance collapsed.

2003 Performance: +25%
Total Fees: $65 million

2004 Performance: +10%
Total Fees: $46 million

2005 Performance: +2%
Total Fees: $30 million

2006 Performance: +14%
Total Fees: $58 million

2007 Performance: +4%
Total Fees: $36 million

2008* Performance: -39% (*Assumes year ends now)
Total Fees: $27 million

Total Fees Over 6 Years: $261 million
Gross Performance Over 6 Years: 1%

But gross results, of course, are meaningless. Every year, while the hedge fund manager was subtracting the fees that eventually added up to his $261 million, he was reducing the amount of capital the clients had in his fund. On a NET basis, therefore, the hedge fund manager's clients LOST $203 MILLION OVER THE SIX YEARS. That's an aggregate loss of 20%.

Over the six years Capital Compensation Partners was in business, therefore, the firm made $261 million, and the firm's clients lost $203 million. All the risk, meanwhile, was borne by the clients, who got obliterated in the end. (See Also: The Hedge Fund Business, Analyzed (Companion Spreadsheet)

And now here's the Fund of Funds version:

Instead of shelling out $261 million in fees and losing 20% of capital over six years, the FOF client paid $375 million of fees and lost 29% of capital. But be our guest: Buy a fund of funds. (Here's the spreadsheet).