How Does a Fund of Funds Work?

October 21, 20226 min read
How Does a Fund of Funds Work?
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Key Takeaways

• A pooled fund that invests in other funds is known as a fund of funds (FOF).

• A useful diversification approach, FOFs can serve to help minimize risk. 

• FOFs can be expense heavy because of stacked management fees.

A pooled investment vehicle aggregating positions in mutual funds, exchange traded funds and hedge funds, a fund of funds (FOF) — as the term implies — is a managed fund that invests in other funds. Key advantages of this approach are professional management and broad diversification. After all, each fund in which the fund of funds invests consists of a wide variety of equity investments, and all of those funds have their own professional managers. 

How Funds of Funds Work

As an example, consider for a moment how a mutual fund works. A group of investors pool their capital to take positions in a broad range of equities. Or, they can choose to focus on a specific type of asset, such as short-term municipal bonds. The fund’s manager selects the investments and the accompanying risk is diluted because of the wide variety of bonds in the fund.

A FOF employs this same concept. 

The fund manager chooses a selection of funds, vets them and invests the group’s capital. However, rather than assembling a portfolio of individual equities, the FOF manager compiles a portfolio of funds. In so doing, this person amplifies diversification to its extreme, which in turn can potentially serve to minimize risk considerably.

Types of FOFs

FOFs can also be set up as funds in their own right, structured as mutual funds, hedge funds, private equity funds or investment trusts. Within these structures, there are two basic classifications— fettered and unfettered. A fettered FOF invests in funds managed by one specific investment company. Unfettered FOFs invest in funds managed by a variety of investment companies. 

Classifications of FOFs include target date funds, target allocation funds, hedge funds of funds and business development companies.

Target date funds– Among the most commonly employed of the FOF approaches, target date funds are usually commissioned by 401(k) retirement plans. With this strategy, asset allocations and diversification adjust automatically as the investor reaches their stated target maturation date.  In practice, this means the funds start out investing aggressively for growth, then shift to an income stratagem as the investor’s retirement age draws near.

Target allocation funds – This FOF approach is centered upon asset allocation, as opposed to a maturation date. The investor specifies the asset allocation weighting they’d like to pursue and the manager populates the portfolio accordingly. The manager decides which funds to include, when changes in the composition of the fund are warranted and the overall management of the portfolio — in keeping with allocation specification. 

Hedge funds of funds – This strategy enables mainstream investors to take part in the hedge fund market. Publicly traded hedge funds of funds present a curated mix of diversified and professionally managed hedge funds. It should be noted however, while this tactic entails less risk than direct investment in hedge funds, it remains more risky than traditional index funds. Hedge fund of funds managers typically impose higher fees as well. 

Business development companies (BDCs) – The least well-known funds of funds, BDCs invest in pools of troubled private companies with valuations of approximately $250 million seeking to regain traction. BDCs profit when loans are repaid, or the funds’ equity positions realize appreciation. BDCs are required to distribute all profits to shareholders, which makes them attractive for investors seeking dividend payments. However, given the nature of the companies with which they work, BDCs also carry a great deal of risk.

Funds of Funds Potential Benefits 

As stated above, the primary advantage of pursuing a FOF strategy is the diversification inherent to the approach. This has the potential to minimize exposure to market volatility. After all, the fund is comprised of funds, which, in turn, are comprised of assets across a broad spectrum of asset classes. 

Further, all of the funds involved are under active management, which provides investors exposure to a large number of professional managers. 

Funds of funds also lower the barriers to entry for a number of asset classes that would be out of reach of mainstream investors. As an example, acquiring a position in a hedge fund typically requires a six-figure minimum investment, a high net worth or both. The FOF approach bypasses those hurdles by pooling a large sum of dollars on behalf of a group of mainstream investors.

Funds of Funds Potential Disadvantages

With all of those managers involved, the fee structure of FOFs can be onerous. As an example, consider a situation in which an FOF charges a 1% management fee. Alongside that is the aggregated 1% fee charged by all of the other managers whose funds comprise the FOF. This amounts to a 2% hurdle over which an investor’s returns must clear before income is generated. 

Liquidity can be an issue in some cases as well. Some FOFs cannot be traded on public exchanges. Investors should be careful to choose a fund functioning in line with their liquidity requirements. 

One more thing, the diversification inherent to FOFs can cut but ways. It is entirely possible to acquire overlapping positions when pursuing an FOF strategy. This can be of particular concern with fettered FOFs, as the same equities could appear in several different funds managed by the investment company. 

FOFs, Diversification and Alternative Investments

Experts often counsel new investors to buy into index funds. These track several companies, rather than one specific company, which introduces some diversification into a portfolio. FOFs do the same, in an amplified fashion, and can also be useful when it comes to achieving a balanced asset allocation in a personal portfolio. That said, a well-balanced portfolio could also benefit from investments with minimal correlation to the public markets.

Traditional asset allocation envisions a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split incorporating 20% alternative assets may also make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less correlated with public equity, and thus offer potential for diversification. This can help protect a portfolio during periods of extreme volatility.

Alternative assets such as these were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors who buy in at very high minimums — often between $500,000 and $1 million. Yieldstreet was founded with the goal of dramatically improving access to alternative assets by making them available to a wider range of investors. Alternative investments of this type may effectively complement a FOF approach to further an investor’s diversification efforts. 

In Summary

Like other pooled investment products, the SEC regulates FOFs. The framework for funds of funds arrangements is set forth in SEC Rule 12d1-4, which was updated in 2020. The Commission also requires FOFs to disclose fees to investors transparently. 

Total net assets in mutual funds invested primarily in other mutual funds surpassed $2.54 trillion as of 2019. According to the SEC, some 40% of all registered funds have holdings in other funds. In other words, the FOF strategy is somewhat commonplace. The Barclay of Funds Index tracks FOFs reporting into its database. As of Q1 2022, those FOFs saw an average return of .33% over the preceding 12 months. Meanwhile, the S&P 500 registered a 7.5% retreat during that same period.

Ultimately, funds of funds have the potential to serve as robust tools for the introduction of asset allocation and diversification into portfolios. However, investors must also be mindful of the potential pitfalls of FOFs when considering this approach.