What is a Fund of Funds? An Investor’s Key to Diversification and Reduced Risk
A fund of funds (FOF), also known as a multi-manager investment, is a pooled investment fund strategically designed to invest in a diverse collection of other funds. Instead of creating a portfolio of individual stocks, bonds, or other securities directly, a FOF’s portfolio inherently contains underlying portfolios of multiple funds.
A Closer Look at FOF Dynamics
FOFs predominantly allocate capital into other mutual funds or hedge funds. Their classification typically falls into two categories:
- Fettered Funds: Limited to investing in funds managed by the FOF’s overseeing management company.
- Unfettered Funds: Broaden their scope to invest in an array of funds across the market, managed by various companies.
Key Takeaways
- A fund of funds aims to pool investments into a diversified array of other funds.
- Primary investments are usually in hedge funds or mutual funds.
- The philosophy is oriented towards achieving optimum diversification with minimized risk exposure.
- Compared to standard mutual funds, FOFs usually carry higher expense ratios.
Operating Principles of a Fund of Funds
The fund of funds (FOF) strategy strives for extensive diversification and effective asset allocation by incorporating various fund categories into one consolidated portfolio.
FOFs manifest in various forms such as mutual funds, hedge funds, private equity funds, or investment trusts. These funds serve differing investment agendas. An FOF might adhere strictly to internal management portfolios (fettered) or be open to external funds managed by varying firms and individuals (unfettered).
Why Opt for a Fund of Funds? The Multifaceted Advantages
FOFs appeal to smaller investors aiming for exposure to a well-diversified portfolio with lower risk. FOF investments also avail investors of professional management expertise typically reserved for high-capital platforms.
Investing in an FOF offers entry to broad asset portfolios which are usually out of reach for individual investors. For instance, hedge funds often necessitate substantial minimum investments and have high net worth prerequisites.
A diligent due-diligence process is another hallmark of FOFs, ensuring vetting both their managers and the underlying funds’ stewards to validate credential authenticity and market acumen.
Potential Drawbacks of Fund of Funds
Despite the beneficial diversification and risk reduction, FOFs come with higher fees than single-manager mutual funds. Additional expenses stem from layered management fees from both the FOF and the underlying individual funds.
Fee Structures in FOFs
FOFs accrue annual operating expenses, denoted via an expense ratio, and additional management fees. Consequently, fees effectively double when considering the underlying funds’ costs.
For example, an FOF charging a 1% annual management fee in conjunction with underlying funds charging another 1% results in an aggregate investor fee approximation of up to 2% annually.
Choosing Viable Fund Managers and Funds
Locating adroit fund managers and high-performing funds can be intricate, especially when confined to a fettered FOF structure leading to potential redundancies in stockholdings—ultimately undermining diversification goals.
Real-World FOF Example: Analyzing Performance Metrics
Though varied, funds of funds’ performance can be monitored. For example, the Barclay Fund of Funds Index reports intricate performance data. During Q1 2022, 156 FOFs averaged a 0.33% return YTD, notably outperforming the S&P 500’s 7.5% loss in the same period.
Prevalence and Regulation of Funds of Funds
While independent mutual funds and ETFs are more prevalent, 40% of all registered funds reportedly have invested in at least one other fund, based on SEC findings.
Across mutual funds investing chiefly in other mutual funds, total net assets eclipsed $2.54 trillion in 2019. All pooled investment products, including FOFs, are regulated by the SEC, under guidelines such as SEC Rule 12d1-4, which standardizes FOF frameworks and transparency mandates, including Acquired Fund Fees and Expenses (AFFE) disclosures.
Related Terms: diversification, asset allocation, hedge fund, mutual fund, SEC regulations, investment strategy.
References
- U.S. Securities and Exchange Commission. “Staff Responses to Questions Regarding Disclosure of Fund of Funds Expenses”.
- BarclayHedge. “Fund of Funds Index”.
- U.S. Securities and Exchange Commission. “SEC Updates Regulatory Framework for Fund of Funds Arrangements”.
