What Is a Fund of Funds? Definition & How It Works

A fund of funds (FoF) is an investment fund that allocates capital across a portfolio of other investment funds, rather than directly investing in individual securities like stocks or bonds. An investor in an FoF holds shares in a single fund that, in turn, holds shares in many underlying funds. This approach provides investors with a diversified portfolio through one investment vehicle. It offers broader market exposure and professional management without needing to research and manage multiple individual investments.

How a Fund of Funds is Structured

A fund of funds operates with a two-tiered investment structure. The FoF pools capital from investors at the top tier. This capital is then allocated to a selection of underlying investment funds, which form the second tier. The FoF manager plays a central role in this arrangement, identifying, evaluating, and selecting these underlying funds based on their performance, management quality, and investment strategy.

Investors acquire shares in the FoF, gaining indirect exposure to the underlying funds’ holdings. Capital flows from the investor to the FoF, and then to the underlying funds. This structure allows for broad exposure across different asset classes, investment strategies, and fund managers. Some FoFs, known as “fettered” funds, invest solely in funds managed by the same parent company, while “unfettered” FoFs invest in funds from various external management companies.

Investment Approach and Portfolio Diversification

Funds of funds achieve broad diversification by investing in multiple underlying funds. This strategy provides exposure across various asset classes, investment strategies, and fund managers, which helps reduce overall portfolio volatility. Spreading investments across different funds aims to smooth returns and potentially mitigate the impact of poor performance from any single underlying fund.

This approach also provides investors with access to specialized or niche investment strategies that might otherwise be difficult to access directly. An FoF can pool capital to meet high minimum investment requirements or overcome limited availability to individual investors, offering access to a wider array of investment opportunities. The professional management inherent in an FoF includes continuous monitoring and rebalancing of the underlying fund portfolio.

Types of Funds of Funds

Funds of funds are classified by the types of underlying funds they invest in or their specific investment objectives.

Hedge Fund of Funds

This common type invests in a portfolio of various hedge funds. These often aim to provide broad exposure to the hedge fund industry and diversify risks associated with a single hedge fund.

Private Equity Funds of Funds

These offer access to a variety of private equity funds within a single investment vehicle, often targeting specific strategies like buyouts or venture capital.

Mutual Fund of Funds

These invest in a diversified portfolio of individual mutual funds, providing broad exposure to various asset classes through these underlying vehicles.

Other Classifications

These include multi-asset FoFs, which invest across different asset types like equities, debt, and commodities, or sector-specific FoFs that focus on funds within a particular industry.

Considerations for Investors

When evaluating a fund of funds, investors should consider the fee structure, which involves “layered fees.” Investors pay management fees at the FoF level and indirectly bear fees charged by each underlying fund. For example, a private equity FoF might charge a management fee of 0.5% to 1.0% and a performance fee of 5% to 10% on gains, in addition to the 1.5% to 2.5% management fees and 15% to 25% performance fees charged by the underlying private equity funds. Acquired Fund Fees and Expenses (AFFE) are disclosed to provide transparency regarding these cumulative costs.

Transparency regarding underlying holdings and investment strategies can be limited in FoFs. While the FoF manager conducts due diligence, direct insight into specific investments at the lowest tier may not always be readily available to the end investor. Assessing the FoF manager’s expertise and track record is important, as their skill in selecting and monitoring underlying funds is central to the FoF’s success. A manager’s track record should span multiple market cycles to demonstrate consistent performance and risk management.

Liquidity considerations are another factor, particularly for FoFs investing in less liquid assets like private equity or some hedge funds. Some FoFs may offer monthly or quarterly redemptions, but underlying funds might have longer lock-up periods or less frequent redemption options. This potential mismatch between the FoF’s redemption terms and the liquidity of its underlying investments could impact an investor’s ability to access capital.