Definition of Fund of Funds
Multi-manager investments, or funds of funds (FOFs), invest in other funds. Thus, its portfolio includes other funds’ portfolios. These assets replace direct bonds, stock, and other securities investments.
FOFs invest in various hedge and mutual funds. They can be “fettered,” investing solely in FOF-managed funds, or “unfettered,” investing in funds throughout the market.
Fund of Funds Operations
The fund-of-funds (FOF) approach seeks to diversify and allocate assets across many categories within a single portfolio.
FOFs operate on several investment schemes. FOFs might be mutual funds, hedge funds, private equity funds, or investment trusts. The FOF may invest only in one investment company’s portfolios. Unfettered, the FOF can invest in external funds that other firms’ managers manage.
Fund of Funds Benefits
FOFs often attract small investors who desire better exposure with fewer risks than investing in securities or individual funds. FOF investors receive wealth management skills.
FOFs allow low-capital investors to access diversified portfolios with diverse assets. Many of them are too expensive for individual investors. Hedge funds usually need six-figure investments or a minimum net worth.
The fund managers of most FOFs—both their own and the underlying funds—must undergo rigorous due diligence. Checking applying managers’ backgrounds verifies the portfolio handler’s securities sector qualifications.
Fund of Funds Drawbacks
FOFs offer diversification and reduced market volatility, but higher investing costs may reduce profits. Fee compounding raises fees.
A FOF, like other mutual funds, has an annual expense ratio, management fees, and operational costs. FOF investors pay twice since the underlying funds have yearly charges.
Funds’ prospectuses didn’t always contain underlying fund fees. Since January 2007, the SEC has mandated disclosing acquired fund fees and expenses (AFFE).
To invest in funds that charge 1% annual management fees, a FOF may charge 0.5% to 1%. Thus, FOF investors pay up to 2%. After fees and taxes, FOF investments may provide lower returns than single-manager funds, even if they perform well.
Choosing competent fund managers and funds is challenging, especially if the FOF is limited. The FOF may own the same stock or investment through many funds, lowering diversity.
Pros
- Ultimate diversification
- Professional management skills
- Reduced risk and volatility
- Assets usually go beyond modest investors
Cons
- Additional charges
- Holdings overlap risk
- It is hard to locate suitable managers and funding
Real-World Fund of Funds Example
Due to their diversity, funds are challenging to track and compare. However, an index exists. Barclay-Hedge, an alternative investing data supplier, sponsors the Barclay FOFs Index, which measures the average return of all FOFs that are reported into the company database. The average return of 156 funds through Q1 2022 was 0.33%. The S&P 500 lost almost 7.5% throughout the same period.
Funds of Funds Common?
Some mutual funds and ETFs are more prevalent than dedicated funds. The SEC believes that 40% of registered funds invest in another fund.
How Much Assets Are Investments in Funds of Funds
The SEC said mutual funds that invest primarily in other mutual funds had over $2.54 trillion in net assets in 2019.
Does the SEC regulate funds of funds?
FOF, like other pooled investment vehicles, is SEC-regulated. For instance, SEC Rule 12d1-4, amended in 2020, establishes standard FOF processes.FOFs must report their fees transparently to the SEC.
Conclusion
- A fund of funds (FOF) pools funds to invest in others.
- FOFs invest in hedges and mutual funds.
- The fund-of-funds approach seeks diversification and low risk.
- Funds of funds have greater expenses than mutual funds.
