What Are Funds of Funds and How Do They Work?
Learn how Funds of Funds work, their unique structure, and what to consider when investing in these multi-layered financial vehicles.
A Fund of Funds (FoF) is an investment vehicle that acquires interests in other investment funds, rather than directly purchasing individual securities. This structure allows investors to gain exposure to a diversified set of underlying investments through a single allocation. The primary aim of an FoF is to offer a comprehensive investment solution by leveraging the expertise of multiple fund managers across various strategies. This can appeal to those seeking broader market access and professional oversight without managing numerous direct investments.
Defining Funds of Funds and Their Structure
A Fund of Funds (FoF) primarily invests in a portfolio of other investment funds, rather than directly in individual securities. This creates a “layered” structure where an investor’s capital flows into the FoF, which then allocates that capital across selected underlying funds. These underlying funds can include mutual funds, hedge funds, private equity funds, or real estate funds, each with its own investment strategy.
The FoF structure means an investor holds shares or units in an FoF, which in turn holds shares or units in other funds. This arrangement places an investor at least two degrees removed from the underlying assets. The FoF manager identifies, selects, and oversees the underlying funds that comprise the FoF’s portfolio.
The objective of this layered structure is to provide professional management and diversification across multiple fund managers and their distinct investment approaches. Some FoFs are “fettered,” investing only in funds managed by the same company. Others are “unfettered,” allowing investment in external funds from different managers. This strategic selection aims to create a cohesive portfolio aligned with the FoF’s investment goals.
Investment Approach of Funds of Funds
The investment approach of an FoF centers on active management and strategic decisions by the FoF manager. Managers conduct extensive due diligence on prospective underlying funds, evaluating their investment strategies, historical performance, risk management practices, and operational integrity. This rigorous selection process identifies funds that complement each other and contribute to the FoF’s objectives.
FoFs can employ various strategies, investing across different asset classes, geographies, or types of funds. An FoF might diversify across mutual funds, hedge funds, private equity funds, or commodity and real estate funds, depending on its mandate. This multi-manager approach provides diversification across assets, investment styles, and decision-makers.
A significant aspect of the FoF structure is its potential to offer access to specialized or otherwise inaccessible underlying funds. Many top-tier or niche funds may have high minimum investment requirements or be exclusive to institutional investors. By pooling capital, an FoF can meet these thresholds, providing individual investors with exposure to opportunities they might not otherwise obtain. This allows for broader exposure and can reduce risks compared to directly investing in a limited range of securities.
Cost Implications for Funds of Funds
Investing in an FoF involves a fee structure often called “layered fees” or “fees on fees.” Investors incur charges at two primary levels. The first layer consists of fees charged by the FoF itself, including management fees and administrative expenses. These fees compensate the FoF manager for selecting and overseeing the underlying funds.
The second layer of fees comes from the underlying funds in which the FoF invests. Each underlying fund charges its own management fees and potentially performance fees, similar to any direct investment. These fees are then passed through to the FoF, indirectly impacting the end investor.
Multiple layers of fees can significantly impact overall investment returns. While FoFs offer convenience and professional management, the cumulative effect of these charges can lead to higher expense ratios compared to investing directly in a single fund or individual securities. Since January 2007, the Securities and Exchange Commission (SEC) has required that acquired fund fees and expenses (AFFE) be disclosed, providing greater transparency to investors.
Comparing Funds of Funds to Direct Investments
A key distinction lies between FoFs and direct investments in individual securities or single funds. With a direct investment, individuals select and manage their portfolio of stocks, bonds, or specific mutual funds. This approach offers greater control and transparency over individual holdings, allowing investors to tailor their portfolio to their preferences.
FoFs involve a more passive role for the end investor, as the FoF manager makes all decisions regarding the selection and allocation of underlying funds. While direct investors are responsible for their own diversification, FoFs provide broad diversification across multiple managers and strategies through a single investment. This appeals to those who prefer to delegate investment management to professionals.
Cost structures also differ substantially. Direct investments typically involve lower, single-layer costs like brokerage commissions or individual fund expense ratios. FoFs, however, come with layered fees, encompassing charges from both the FoF itself and all underlying funds it holds. This can result in a higher overall cost for the convenience and expanded diversification offered by an FoF. Transparency also varies, as direct investors have immediate insight into their specific holdings, while FoF investors are several layers removed from the ultimate underlying assets.