What Is a Fund of Funds (FOF)?
A fund of funds (FOF) is one that, instead of investing in a pool of securities like stocks and bonds, buys shares in other funds. These “multi-manager” investments offer investors further diversification and access to the expertise of other skilled fund managers.
The fund-of-funds approach has grown in recent years, particularly among institutional investors like pension funds and endowments seeking to spread risk and maximize returns. While open-end funds as a whole have grown 42% in assets worldwide from the first quarter of 2020 to the end of 2023, FOFs have grown 58%.
However, FOFs are “infamous,” as a Financial Times analysis put it, for their extra layers of fees. You pay not only for the fund in which you’re directly invested, but also for those funds where the asset manager places your capital. FOFs also make investing more obscure, with the additional funds’ allocations a further remove from your reported allocations. Below, we explain how these funds work and walk you through their potential benefits and drawbacks.
Key Takeaways
- FOFs pool investments in other funds for broader diversification.
- Fund managers use this approach to diversify among different kinds of funds and access expertise they might not have.
- Generally, investors have to expect higher expense ratios than other funds.
- FOFs offer the potential for more stable yet lower returns because of their wider investment exposure.
How Funds of Funds Work
The core idea behind a fund-of-funds strategy is that by combining various hedge fund strategies into a single portfolio, investors can achieve higher returns with less risk compared with investing in individual funds themselves. This diversification aims to smooth out the volatility inherent in fund investing, offering a more stable path to potential gains. Funds of funds are found for all kinds of strategies and include hedge, exchange-traded, mutual, private equity, and other funds.
FOFs work by pooling capital from investors and allocating it in underlying funds. For the most part, FOF managers select these funds based on their performance, management quality, and investment strategy. This involves due diligence, including analyzing past returns, measures of risk, and fund managers’ expertise.
While traditional FOFs focus on actively managed hedge funds, newer FOFs invest in more passive indexes and exchange-traded funds (ETFs). These more passive FOFs aim to provide investors with exposure to a broad range of asset classes and investment strategies at a lower cost compared with actively managed FOFs. There’s still active management at the FOF level, though, since there’s the need to find those indexes or ETFs that align with the FOF’s investment objectives and risk profile.
The fees for a FOF strategy typically involve two layers: the fees charged by the underlying funds and the fees imposed by the FOF manager. For example, if an investor places $10,000 in a FOF with a 1% management fee and the underlying funds collectively charge 2%, the total annual fees might be $298 ($100 for the FOF and $198 for the underlying funds after paying the first fee). This is simplified, but there’s no doubt these fees add up, especially when including performance fees, hurdle rates, and other expenses that could further impact the total cost for the investor.
Types of Funds of Funds
FOFs offer investors access to a diversified portfolio of funds through a single investment. By pooling capital and spreading it across various underlying funds, FOFs provide professional management, diversification, and access to strategies or managers that may otherwise be difficult for individual investors to obtain.
FOFs come in various types, each designed for different investor needs, risk preferences, and investment objectives. These types can be broadly categorized based on the underlying assets they invest in, such as hedge funds, mutual funds, private equity, real estate, or commodities. In addition, some FOFs employ specific trading strategies or invest in particular sectors or geographic regions.
The table below provides an overview of the main types of FOFs. As with any investment, it’s crucial to conduct due diligence before investing in a FOF. Factors to assess include the FOF’s investment strategy, managers’ track records, fees, liquidity, and risks.
| Funds of Funds Types | |||
|---|---|---|---|
| Funds-of-Funds Type | Description | Target Investor | Example Investments |
| Multi-Manager Funds | Invest in a wide range of assets, including hedge funds, private equity, real estate, and traditional investments like stocks and bonds. | High-net-worth individuals (HNWI), institutional investors seeking diversified exposure to the hedge fund space. | Goldman Sachs Multi-Manager Alternatives Fund: This fund allocates assets to many sub-advisors, such as Acadian Asset Management and Algert Global LLC, to manage different portions of the portfolio. |
| Fund of Hedge Funds | Primarily invest in hedge funds, often with specific themes or strategies. | Sophisticated investors with a high-risk tolerance and seeking exposure to alternative investment strategies. | Liongate’s Fund of Hedge Funds: This fund focuses on themes like global macro and managed futures funds. |
| Fund of Mutual Funds | Invest in a diversified portfolio of mutual funds across different asset classes. Target-date funds can be one example. | Retail investors seeking diversified exposure to the market through professional management. | Vanguard Target Retirement 2045 Fund Investor Shares (VTIVX): This target-date fund invests in other Vanguard mutual funds to create a diversified portfolio that adjusts over time. |
| ETFs of ETFs | Automatically adjust their asset allocation over time, becoming more conservative as the target retirement date approaches. | Investors seeking a hands-off approach to retirement planning with a diversified portfolio. | iShares Core Moderate Allocation ETF (AOM), which tracks an index of equity and fixed- income funds, representing represent a moderate target risk allocation strategy. |
| Private Equity Funds of Funds | These funds invest in multiple private equity funds, providing diversified exposure to various private equity strategies (e.g., buyout, venture capital, growth equity) and managers, potentially reducing risk. | Typically cater to institutional investors and HNWIs seeking to access the private equity market while providing access to certain private equity fund managers whom investors might not otherwise be able to invest with. |
Adams Street Partners, HarbourVest Partners, Goldman Sachs AMS Group, and Pantheon Ventures have some of the largest funds of private equity funds. |
| Real Estate Funds of Funds | Focuses on investing in a diversified portfolio of real estate investment funds rather than directly purchasing real estate properties or real estate securities. These other funds might be focused on specific types of properties or real estate investment trusts. | Investors looking for exposure to the real estate market without the need to directly manage properties or conduct extensive research on individual real estate investments. | BlackRock Multi-Manager Real Estate Fund: This fund is designed to provide investors with diversified exposure to various real estate investment strategies by investing in a selection of underlying real estate funds. |
| Infrastructure Funds of Funds | Invest in multiple infrastructure funds, focusing on projects like transportation, energy, and utilities. | Long-term investors such as pension funds, insurance companies, and HNWIs. | HSBC Infrastructure Basket, which adds Roman numerals going in order for the project funds in which it’s invested. |
| Commodity Funds of Funds | Invest in a portfolio of commodity-focused funds, including those targeting metals, energy, and agricultural products. | Investors seeking diversification into commodities to hedge against inflation or other market risks. | GAM Commodity Fund, which invests in a mix of other commodity funds. |
| Debt Funds of Funds | Focus on investing in various debt funds, including those targeting high-yield bonds, corporate debt, and sovereign debt. | Investors seeking income generation and diversified exposure to debt instruments. | Franklin India Dynamic Accrual Funds of Funds: These funds invests in a mix of Franklin Templeton’s debt funds. |
Advantages and Disadvantages of Investing in FOFs
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Additional diversification
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Access to premium investment opportunities
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Professional management
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Simplified investment process
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Higher expense ratios
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The risk of diluted returns
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Complexity and risk of overlap in holdings
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Opaque nature of the investment
Advantages of Investing in a FOF
Investing in a FOF provides several advantages that may appeal to a wide range of different investors (individual and professional).
- Access to premium investment opportunities: FOFs often grant access to exclusive investment opportunities that individual investors might not otherwise reach. By pooling capital, these funds can invest in high-performing mutual, hedge, or private equity funds, enabling investors to participate in sophisticated strategies and high-potential ventures typically reserved for institutional players.
- Diversification: FOFs offer exceptional diversification by investing in various underlying funds, spreading risk across multiple asset classes and investment strategies. This broader investment exposure can help mitigate the impact of individual poor fund performers, which may result in more stability and possibly higher returns over time. That said, being spread too thin can lower the potential for returns.
- Professional management: Another significant benefit of FOFs is their professional management. Experienced fund managers conduct thorough due diligence, select quality funds, and continuously monitor and rebalance the portfolio. If done well, this expertise can lead to better asset allocation, risk management, and performance.
- Simplified investment process: FOFs simplify the investment process by bundling multiple funds into a single investment vehicle. This convenience allows investors to achieve broad market exposure and possibly effective diversification without the need to research and manage each investment themselves. It streamlines portfolio management, making it an attractive option for novice and experienced investors.
Fettered and Unfettered FOFs
FOFs come as either “fettered” or “unfettered.” Fettered FOFs invest only in funds managed by the same company, while unfettered FOFs don’t have to do so.
Disadvantages of Investing in a FOF
While FOFs offer several benefits, they also have drawbacks that investors should consider carefully.
- Higher expense ratios: FOFs have higher expense ratios because of the layered fees. Investors pay fees not only for FOF management but also for underlying funds. These cumulative costs can significantly eat into overall returns, making FOFs more expensive than direct fund investments.
- Diluted returns: The extensive diversification in FOFs can sometimes lead to weaker returns. By spreading investments across many funds, the performance of high-performing assets may be offset by lower-performing ones. This broad exposure can result in more stable, potentially lower, overall returns.
- Complexity: Understanding and evaluating FOFs can undoubtedly be complex because of their multilayered nature. Investors need to understand not just the strategy of the FOF but also the underlying funds’ strategies and performance. This makes it quite difficult to evaluate the risks involved.
- Opaque nature of the investment: FOFs are less transparent than funds with direct investments. The multiple layers of funds can obscure the visibility of individual holdings and strategies, making it difficult for investors to fully understand where their money is actually invested.
Multi-Strategy Funds (MSFs) vs. FOFs
In the past decade, many hedge funds have advertised offerings for multi-strategy funds (MSFs), a moniker that has spread to others. Given that FOFs were becoming known for excessive fees, MSFs seemed to some as putting new wrapping on an older idea. However, while in some cases—when multiple funds are being invested in—this is true, there are differences between MSFs and FOFs worth setting out.
A multi-strategy fund has a single manager who oversees multiple investment strategies. In most cases, this shouldn’t mean the manager is just average at many methods. Instead, most multi-strategy fund managers have achieved (or employ those who have) expertise in several strategies and rely on a team of specialists in each area. The manager might have a background in one specific strategy—say, bonds—but may incorporate new ones over time to increase the fund’s capacity or capitalize on new prospects.
MSFs are suitable for investors seeking a diversified portfolio with a single manager, potentially lower fees, and the ability to adapt to changing market conditions more quickly since all control is under one roof. However, it’s easy to see the concern that a manager might not be up to handling different strategies simultaneously. Thus, FOFs may appeal more to investors who value diversified exposure with multiple managers and are comfortable with potentially higher fees.
Considerations for Investors
When considering investing in a FOF, assessing your investment goals and risk tolerance is crucial. Ensure you determine whether your primary goals are growth, income, or stability and that the chosen FOF aligns with your risk appetite. Understanding these factors can help you tailor your investment strategy to meet long-term financial goals.
Undoubtedly, understanding fees and expenses is another critical consideration. While researchers still debate whether the gains of investing in multiple funds surpass their fees, there’s no doubt that FOFs often have significantly higher expense ratios. These cumulative costs can greatly impact your overall returns. Therefore, it’s essential to fully comprehend the fee structure before committing to an FOF investment.
Besides that, conducting thorough research and due diligence is paramount. Evaluate the track record of the FOF managers, scrutinize the underlying funds’ performance and strategies, and ensure transparency in reporting. A rigorous evaluation can help you understand the potential risks and rewards and give you more confidence when deciding.
How Do FOFs Fit into a Long-Term Investment Strategy?
FOFs usually provide broad diversification as well as professional management, making them suitable for long-term stability and growth. However, higher expenses may dilute overall returns over time.
Can Individual Investors Create Their Own Fund of Funds?
Individual investors can create a similarly diversified portfolio by selecting various mutual or hedge funds themselves, but this takes expertise in choosing among these funds.
Are Funds of Funds Regulated by the U.S. Securities and Exchange Commission (SEC)?
Like all other pooled investments, FOFs are overseen by the SEC. In particular, SEC Rule 12d1-4, updated in 2020, sets out procedures that provide a consistent framework for fund of funds arrangements. It allows FOFs to own more of another fund than usually permitted, but with conditions. These include preventing excessive control, restricting voting rights, and requiring detailed disclosures.
How Do Economic Downturns Affect the Performance of FOFs?
Recessions will certainly impact FOFs, but their diversified nature should mitigate some risks compared with individual investments.
The Bottom Line
FOFs offer a diversified investment strategy by pooling various funds, often providing access to exclusive prospects and professional management. However, they come with higher expense ratios and the potential for diluted returns. Understanding the fees, conducting thorough research, and assessing how FOFs fit your long-term goals are crucial. Despite their complexity, FOFs can be a valuable part of a well-rounded investment portfolio.