What Are Funds of Funds? How They Work, Types, and Fees

Funds of funds (FoFs) are investment vehicles that diversify portfolios by investing in a collection of other professionally managed funds, rather than directly acquiring individual securities. This approach streamlines the investment process for those seeking broad market exposure or access to diverse strategies.

Defining Funds of Funds

A fund of funds (FoF) operates as an investment vehicle that primarily allocates its capital to other investment funds, rather than holding direct investments in individual securities like stocks or bonds. This layered structure means investors place money into the FoF, which then distributes it across a selection of underlying funds. These underlying funds, in turn, invest directly in specific assets or implement distinct strategies.

The objective of an FoF is to offer broad diversification and access to various investment strategies or specialized fund managers through a single investment. By pooling capital across multiple underlying funds, an FoF mitigates risks associated with any single investment or manager. This structure provides exposure to a range of investment styles, asset classes, or geographic regions that might otherwise be difficult to access individually.

FoFs simplify building a diversified portfolio. Instead of researching and managing numerous individual fund managers, investors rely on the FoF’s management team. This consolidated approach provides exposure to diverse investment opportunities, often including those with high minimum investment requirements or complex structures.

How Funds of Funds Operate

The operation of a fund of funds involves several distinct processes, beginning with the selection of underlying managers. FoF managers conduct due diligence to identify suitable investment funds. This process includes qualitative analysis, assessing the management team’s experience, investment philosophy, and risk management, and quantitative analysis, examining historical performance, risk metrics, and correlation with other potential holdings.

Following manager selection, the FoF engages in portfolio construction, strategically allocating capital across the chosen underlying funds. This allocation aims to achieve diversification across various dimensions, such as investment strategies, asset classes, geographic regions, or market sectors. The goal is often to create a balanced portfolio that performs consistently across different market conditions, while aligning with the FoF’s overall investment objectives.

Ongoing monitoring is a continuous aspect of an FoF’s operations. The management team regularly reviews the performance of underlying funds and managers, assessing their adherence to strategies and evaluating risk exposures. This oversight allows for timely adjustments, such as rebalancing the portfolio or replacing underperforming funds, to maintain the desired risk-return profile.

Funds of funds also provide consolidated reporting to their investors, simplifying administrative tasks. These reports summarize overall portfolio performance, provide insights into underlying holdings, and detail any allocation changes. This transparency helps investors understand their single FoF investment.

Types of Funds of Funds

Funds of funds are categorized by the types of underlying investment funds they target, reflecting diverse investment landscapes and objectives.

Hedge Fund of Funds

This type invests in a portfolio of various hedge funds. These FoFs provide diversified exposure to different hedge fund strategies, such as long/short equity, global macro, or event-driven, which often have high minimum investment thresholds for direct entry.

Private Equity Funds of Funds

These vehicles invest in a collection of private equity funds, encompassing strategies like venture capital, buyout funds, growth equity, and distressed debt. Private equity FoFs offer access to illiquid private markets, allowing investors to participate in a diversified pool of private companies without committing directly to individual private equity funds, which often require substantial capital commitments over long periods.

Mutual Fund Funds of Funds

Prevalent in retail investment products, these FoFs invest in a diversified portfolio of underlying mutual funds, including equity, bond, or money market funds. A common application is in target-date funds, where allocation to underlying mutual funds automatically adjusts to become more conservative as the target retirement date approaches.

Real Estate Funds of Funds

These specialize in investing in various underlying real estate funds. They can include funds focused on different property types (e.g., commercial, residential, industrial) or investment strategies (e.g., core, value-add, opportunistic). Such FoFs provide a diversified avenue for investors to gain exposure to real estate markets, bypassing the complexities of direct property ownership or individual real estate fund selection.

Understanding Fees and Costs

Investing in a fund of funds involves a distinctive “double layer” of fees, which impacts overall returns. The primary layer consists of management fees charged by the fund of funds itself. These fees compensate the FoF manager for due diligence, portfolio construction, ongoing monitoring, and consolidated reporting. These management fees typically range from 0.5% to 2.0% of assets under management annually, depending on strategy complexity and service level.

The second layer of fees comes from the underlying funds. Each individual fund charges its own management fees. Alternative investment funds, like hedge funds or private equity funds, may also charge performance fees. For example, a hedge fund might charge a “2 and 20” fee structure, meaning a 2% annual management fee and 20% of profits above a hurdle rate. FoF investors effectively bear both layers of costs.

This dual fee structure means the total expense ratio for an FoF can be higher than that of a direct investment in a single fund or individual securities. For instance, if an FoF charges 1% and invests in underlying funds that collectively charge an average of 1.5% in management fees, the effective management fee paid by the investor would be approximately 2.5% before any performance fees. Understanding the combined impact of these fees is important, as they directly reduce the net returns realized by the investor. Investors should review the FoF’s offering documents to ascertain all applicable fees and their potential effect on investment performance.