What is a fund of funds (FOF)?
A fund of funds (FOF), also known as multi-manager investing, is a mutual fund that invests in other types of funds. In other words, his portfolio contains different portfolios underlying other funds. These holdings replace any direct investment in bonds, stocks and other types of securities.
FOFs generally invest in other UCIs or hedge funds. They are generally classified as “chained”, or only able to invest in funds managed by the management company of the FOF, or “without barriers”, or capable of investing in funds through the market.
How a fund of funds works
The fund of funds (FOF) strategy aims to achieve broad diversification and appropriate asset allocation with investments in a variety of fund categories, all of which are grouped in a portfolio.
There are different types of investment funds, each type acting on a different investment plan. An FOF can be structured as a mutual fund, a hedge fund, a private equity fund or an investment trust. The FOF can be hindered, which means that it only invests in portfolios managed by a single investment company. Alternatively, the FOF can be unhindered, allowing it to invest in external funds controlled by other managers from other companies.
Key points to remember
- A fund of funds (FOF) is a mutual fund that invests in other funds.
- FOFs generally invest in other hedge funds or mutual funds.
- The fund of funds (FOF) strategy aims to achieve broad diversification and minimal risk.
- Funds of funds tend to have higher expense ratios than regular mutual funds.
Benefits of the fund of funds
Typically, investment funds attract smaller investors who want better exposure with less risk compared to direct investment in securities, or even individual funds. Investing in an FOF offers the investor professional services and expertise in wealth management.
Investing in an FOF also allows investors with limited capital to tap into diversified portfolios with different underlying assets. Many of them would be out of reach for the average retail investor. For example, hedge funds generally require minimum six-digit investments or require investors to have minimum net worth, or both.
Most FOFs require a formal due diligence process for their fund managers – their own and those who manage the underlying funds. The application of the managers’ background is verified, which guarantees the portfolio manager’s background and references in the securities sector.
Ultimate in diversification
Professional management expertise
Risk and volatility mitigation
Exposure to assets generally beyond small investors
Additional layer of fees
Risk of overlap on farms
Difficulty finding qualified managers, funds
Disadvantages of the fund of funds
Although investment funds offer diversification and less exposure to market volatility, these returns can be reduced by investment fees that are generally higher than traditional investment funds. Higher fees come from the combination of fees in addition to the fees.
Like most mutual funds, an FOF has annual operating expenses, called the expense ratio, as well as management fees and operating expenses. However, FOF investors pay essentially double, as the underlying FOF funds also have all of their annual costs and fees.
In the past, prospectuses for funds of funds did not always include the costs of the underlying funds. In January 2007, the SEC began to require that these fees be disclosed on a line called “Acquired Fund Fees and Expenses” (AFFE).
A fund of funds may charge annual management fees of 0.5% to 1% to invest in funds that still charge 1% of annual management fees. Thus, the FOF investor pays in sum up to 2%. It is not surprising that after allocating the money invested in fees and other taxes payable, the returns on investments in funds of funds can generally be lower than the profits that single manager funds can provide, even if funds work fine.
Choosing good fund managers and good funds can also be difficult, especially if the FOF is chained. The FOF may end up holding the same or another security through several different funds, thereby reducing actual diversification.
Real-world example for the fund of funds
Since they are so varied, funds of funds can be difficult to track as a group and to compare. However, an index exists. The Barclay Fund of Funds Index, sponsored by Barclay-Hedge, an alternative investment data provider, is a measure of the average return of all OFFs that relate to the company’s database; it includes 500 to 650 funds. As of March 2019, 583 funds have had an average return of 3.95% since the start of the year.