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Fund of funds

What Is a Fund of Funds?

A fund of funds (FOF) is an investment vehicle that primarily invests in other collective investment funds rather than directly in individual stocks, bonds, or other securities. Operating within the broader category of Investment Vehicles, a fund of funds essentially creates a diversified portfolio of underlying funds. This structure aims to provide investors with broader diversification across various asset classes, geographic regions, or investment strategies through a single investment. Instead of selecting multiple individual funds, an investor can allocate their investment capital into a fund of funds, which then undertakes the selection and oversight of several underlying funds, offering a layer of professional management. The appeal of a fund of funds often lies in its ability to offer access to specialized managers or less accessible markets.

History and Origin

The concept of a fund of funds began to emerge in the 1960s, a period marked by increasing complexity and specialization in financial markets. One of the earliest examples of a fund of funds was established by Bernie Cornfeld in 1962. These initial structures sought to aggregate investor capital to gain broader exposure to various investment opportunities, including nascent hedge funds that were often difficult for individual investors to access directly. The growth of this approach was significantly driven by institutional investors like pension funds and endowments, who increasingly looked for ways to spread risk and potentially enhance returns across a wider spectrum of investment styles and managers. Over time, the fund of funds model evolved to encompass various types of underlying funds, including private equity funds and traditional mutual funds.

Key Takeaways

  • A fund of funds invests in a portfolio of other investment funds, rather than directly in securities.
  • This structure provides enhanced diversification by spreading investments across multiple underlying funds, managers, and strategies.
  • Investors in a fund of funds gain access to professional management and potentially to specialized or otherwise inaccessible investment opportunities.
  • Fund of funds arrangements typically involve layered fees, meaning investors pay fees at both the fund of funds level and the underlying fund level.
  • While offering benefits like convenience and broad exposure, these structures can also lead to diluted returns and reduced transparency.

Interpreting the Fund of Funds

When evaluating a fund of funds, investors should consider its stated investment objective, the types of underlying funds it invests in, and its overall fee structure. A fund of funds is interpreted primarily through the collective performance and diversification it offers. Its value is not derived from a single asset but from the aggregate performance of the portfolio of funds it holds. For instance, a fund of hedge funds might be interpreted as a means to gain diversified exposure to various alternative investments and trading strategies, reducing reliance on any single hedge fund manager's performance. Similarly, a fund of private equity funds provides exposure to multiple private equity vintages and strategies, aiming to smooth out the illiquid nature of individual private equity deals. The primary interpretation is that a fund of funds serves as a "one-stop shop" for a diversified portfolio across a specific segment of the investment universe.

Hypothetical Example

Consider an investor, Sarah, who has $100,000 to invest and wants broad exposure to different market sectors and styles, but lacks the time or expertise to research and select numerous individual mutual funds or exchange-traded funds (ETFs). Sarah decides to invest in a "Diversified Growth Fund of Funds."

This hypothetical Fund of Funds, managed by "Global Capital Advisors," doesn't buy individual stocks. Instead, it invests Sarah's money (along with other investors' investment capital) into a curated selection of five underlying mutual funds:

  1. Fund A: A large-cap U.S. equity fund.
  2. Fund B: An international developed markets equity fund.
  3. Fund C: A global bond fund.
  4. Fund D: A U.S. small-cap growth fund.
  5. Fund E: An alternative investment fund specializing in real estate investment trusts (REITs).

Global Capital Advisors' fund of funds has an expense ratio of 0.50% per year. Each of the underlying funds (A, B, C, D, E) also has its own expense ratio, averaging about 0.75% annually. So, Sarah indirectly pays both Global Capital Advisors' fee and the fees of the underlying funds.

If Sarah's $100,000 investment grows to $108,000 in a year (an 8% gross return from the underlying funds), after the layered fees (approximately 1.25% total, or $1,250 on $100,000), her net return would be closer to $106,750, or 6.75%. This example illustrates how the fund of funds provides diversification and professional selection but also introduces an additional layer of costs.

Practical Applications

Fund of funds structures are employed across various segments of the financial market, catering to diverse investor needs and goals.

  • Diversification and Access: A primary application is to offer enhanced diversification across a broad range of underlying funds, thereby spreading risk management across multiple asset classes, sectors, or geographies.6 They can also provide access to exclusive investment opportunities, such as certain hedge funds or private equity funds, which might have high minimum investment requirements or be otherwise inaccessible to individual investors.
  • Simplified Investment Process: For investors who desire a diversified portfolio management approach but lack the time or expertise to select and manage multiple individual funds, a fund of funds simplifies the investment process by bundling various funds into a single vehicle. This can be particularly appealing to novice investors or those with limited capital who still seek broad exposure.
  • Institutional Investing: Many institutional investors, including pension funds and endowments, utilize fund of funds structures to manage their allocations to complex or less liquid alternative investments. This allows them to delegate manager selection and due diligence to the fund of funds manager.
  • Regulatory Framework: The U.S. Securities and Exchange Commission (SEC) has a specific regulatory framework for fund of funds arrangements under the Investment Company Act of 1940. In October 2020, the SEC adopted Rule 12d1-4 to streamline and enhance this framework, permitting registered funds to acquire securities of other registered funds in excess of certain limits, subject to specific conditions.5 These conditions include limits on control and voting, required evaluations, and, for funds that do not share the same investment adviser, a mandatory fund of funds investment agreement.4

Limitations and Criticisms

While a fund of funds offers distinct advantages, it also carries notable limitations and has faced significant criticism, primarily concerning its cost structure and potential for diluted returns.

  • Layered Fees: The most common criticism of a fund of funds is the "fees on fees" structure. Investors pay management fees and expenses at the fund of funds level, as well as the underlying management fees and expenses charged by each of the component funds. This cumulative cost can significantly erode overall investment returns. Academic research has questioned whether these additional layers of fees are justified by the value added by the fund of funds manager.3
  • Diluted Returns: The extensive diversification inherent in a fund of funds, while reducing risk, can sometimes lead to diluted returns. By investing in a broad array of underlying funds, the potential for any single high-performing fund to significantly boost overall returns is lessened. This effect can be exacerbated by the additional layer of fees, potentially leading to lower net returns compared to direct investments in individual funds.
  • Lack of Transparency: Fund of funds structures can make it more challenging for investors to fully understand their actual underlying holdings and exposures. The additional layer of management means investors are further removed from the specific investment decisions being made within the underlying funds, which can complicate risk management and portfolio analysis.
  • Over-diversification and Overlap: While diversification is a key benefit, excessive diversification within a fund of funds can lead to a phenomenon known as "diworsification," where too many holdings dilute the impact of strong performers without meaningfully reducing overall portfolio risk. There is also a risk of significant overlap in holdings among the underlying funds, which can negate some of the intended diversification benefits.
  • Liquidity Constraints: Some fund of funds, particularly those investing in less liquid alternative investments like private equity funds or certain hedge funds, may impose restrictions on withdrawals or transfers. This can make it difficult for investors to access their capital quickly, reducing the overall liquidity of the investment.2

Fund of Funds vs. Mutual Fund

The terms "fund of funds" and "mutual funds" are often confused, but they represent different levels of investment structure.

A mutual fund is a collective investment vehicle that pools money from many investors to invest directly in a diversified portfolio of securities like stocks, bonds, or money market instruments. It is the primary layer of investment where the fund manager directly selects and trades individual assets based on the fund's investment objective. Investors buy shares of the mutual fund, and the value of these shares fluctuates with the underlying securities.

In contrast, a fund of funds (FOF) is a type of investment vehicle that invests in other mutual funds (or other types of funds like hedge funds or private equity funds) rather than investing directly in individual securities. An FOF does not typically hold stocks or bonds directly but instead holds shares of multiple underlying funds. The FOF manager's role is to select and oversee these underlying funds, providing a layer of professional management over a portfolio of funds. The key distinction lies in what the fund directly holds: a mutual fund holds securities, while a fund of funds holds other funds.

FAQs

Q1: What is the main advantage of investing in a fund of funds?
A1: The primary advantage is enhanced diversification and simplified access to a broad range of investment strategies and managers through a single investment. It allows investors to spread their risk across multiple underlying funds without the need to select each one individually.

Q2: Are fund of funds more expensive than traditional funds?
A2: Generally, yes. Fund of funds typically have higher fees due to their layered structure. Investors pay the management fees of the fund of funds itself, as well as the fees charged by each of the underlying funds in its portfolio. This "fees on fees" structure can result in a higher overall expense ratio compared to directly investing in a single mutual fund.1

Q3: Who typically invests in a fund of funds?
A3: Fund of funds can appeal to a wide range of investors. They are often used by institutional investors seeking diversified exposure to alternative investments like hedge funds or private equity funds. They can also be suitable for individual investors who desire a professionally managed, diversified portfolio but prefer a simpler investment approach with less direct involvement in selecting multiple funds.

Q4: How are capital gains taxed in a fund of funds?
A4: The tax treatment of a fund of funds depends on its legal structure and the nature of its underlying investments. For registered investment companies that are structured as FOFs, capital gains and income distributions from the underlying funds are passed through to the FOF's investors, who are then subject to taxation based on their individual tax situation, similar to how traditional mutual funds are taxed. The layering of fees, however, can reduce the net taxable gain.