Fund of Funds Fees: Understanding the Layers

A fund of funds is a private fund that invests in a collection of other funds rather than directly in companies or assets. The idea is to give investors access to several underlying managers through one vehicle.

Fund of funds fees usually refer to the costs charged at the top level, by the fund of funds manager, along with the costs charged inside each underlying fund. This is sometimes described as a layered or double fee structure.

Common fee terms include management fees, performance-based compensation (often called carried interest or an incentive allocation), and fund expenses such as administration, legal and audit costs. The exact terms are set out in each fund's own offering documents and can differ widely.

Private fund investments are speculative and illiquid and can lose all of their value.

Traditionally, investors have looked at fund of funds fees in two parts: what the fund of funds manager charges, and what the underlying managers charge. Reading both is part of understanding the total cost of participating.

Some investors have viewed the extra layer as payment for services such as manager selection, due diligence, portfolio construction and administrative simplification. Others have preferred to invest directly with underlying managers to avoid a second layer. Both approaches are common and reflect different priorities.

Access to a fund of funds is generally limited to accredited investors under SEC Rule 501(a), and offerings are typically made under Rule 506(b), which prohibits general solicitation, or Rule 506(c), which allows general solicitation but requires that all purchasers be accredited and that the issuer take reasonable steps to verify status. Investors in these vehicles often receive a Schedule K-1, and tax treatment depends on individual circumstances.

The right fund manager may help you understand how fees are structured and how they fit into the larger picture of a portfolio. A good conversation is generally less about a single number and more about what you receive for the costs involved.

In a typical introductory conversation, a manager may walk through the fee terms in the offering documents, explain how fees are calculated and paid, and describe how expenses are allocated. You can also ask how they select underlying funds and what services the added layer is meant to provide.

Helpful questions to bring: What fees apply at each level? Are there any fees on fees? How are expenses charged? Are there any hurdles or clawbacks on performance compensation? What are the liquidity terms? How are conflicts of interest handled? Past performance does not guarantee future results, so also ask how any track record is presented. Always review the issuer's offering documents and consult your own licensed investment, legal and tax advisers.