“What is the actual purpose of Fund of Funds” famed money manager and financial blogger Barry Ritholtz asks.
The idea that fund of funds perform due diligence, the forensic accounting and deep background checks on hedge funds has been blown out of the water by the revelations of Bernie Madoff’s scam. Funds of Funds poured money into Madoff’s Ponzi scheme, apparently never bothering to check if it was a legitimate operation.
In fact, it was always pretty improbable that funds of funds were doing lots of due diligence.
To understand why it was improbable, just take a look at some of the biggest and most popular hedge funds. Do you think that Stevie Cohen lets the managers from a fund of funds run through his books, review his strategies and inspect the SAC Capital offices? How many fund of funds folks do you think have been able to grill the folks at Renaissance Technologies Corp? Interview the physicists at Citadel?
Exactly. These fund of funds folks are not only not doing due diligence. They can’t.
So what is it that a fund of funds does to earn its fees? What investors are buying when the hand over money to a fund of funds is the opportunity to get in on the returns of some of the biggest names in the hedge fund world with a relatively small investment. Many of the most prominent funds are closed to new investments or require enormous initial investments. But a fund of funds will let you in for, say, as little as $500,000. You probably couldn’t get Ken Griffin, the founder of Citadel, to even answer your calls with a $500,000 check.
That’s what the funds of funds are selling: access. Of course, as some of the gilt rubs off the hedge fund business, this access may have diminishing value. Do you really want to pay extra fees just to have Citadel lose half your investment? Perhaps some will actually begin to perform actual services for investors, such a due diligence investigations, in order to gain or keep market share. And perhaps, as hedge funds get more desperate for assets under management, the hedge fund managers will actually allow them to perform those services.