A fund of funds (FOF) is an investment fund that invests in other investment funds.
The term “fund” refers to a bundle of investment assets. For example, if you invest in a traditional investment fund, like a mutual fund, your share is made up of stocks from multiple companies. Now, if that mutual fund invests in other mutual funds, you have a fund of funds. One pooled fund is investing in other pooled funds.
How a Fund of Funds Works
The goal of investing in a fund of funds is to instantly create a widely-diversified investment portfolio, without having to choose individual investments (or even individual investment funds).
Here’s how a FOF works from the individual investor’s perspective:
You, as an individual investor, know you don’t want to “put all your eggs in one basket;” you want to spread your investment capital among a wide range of industries so that your portfolio has some protection against a market disruption in any single industry. You could invest in a fund. But that only offers a certain degree of diversification since most funds specialize in a single industry or category.
Instead, you decide to invest in a fund of funds. This one investment vehicle is made up of multiple funds, giving you a well-diversified portfolio with a single investment.
The FOF serves as your point of access to all the other funds. This streamlined investor experience allows you to monitor the aggregate performance of potentially hundreds of stocks, bonds, and other investments. And, because your fund of funds is monitoring the performance of the individual funds that comprise your portfolio, they can advise you on options for changing your portfolio as needed.
FOFs can be structured in one of two ways:
Fettered: the fund of funds only invests in funds from a specific investment company. OR
Unfettered: the fund of funds can invest in any available funds on the market.
Neither option is necessarily better than the other; they both have advantages. With unfettered funds, the FOF’s manager will be able to select from a wide pool of fund options. But with fettered funds, the FOF’s manager may be more knowledgeable about the funds that make up the fund of funds.
Here’s how this works from the fund of funds’ perspective:
As the fund of funds’ manager, you are responsible for selecting the funds to include in your FOF bundle. This decision is critical for ensuring successful investments for your investors. Monitoring the performance of the individual funds will help you choose the best funds for your investors, and it will help you make any necessary changes to your fund of funds to help maximize returns for your investors.
It is also your responsibility to put all dollars in your fund of funds to work for your investors. In some cases, managers find themselves with extra investment capital on hand. Rather than sitting on cash, you should invest that excess in a short-term investment vehicle to increase your investors’ returns.
Because FOF managers are typically paid a percentage of the investment portfolio, it is in your best interest to generate impressive returns for your investors to grow their wealth and incentivize them to keep their capital in your fund of funds.
Benefits of Fund of Funds Investing
Fund of fund investing provides several benefits for individual investors, including
Comparatively little research time. Rather than reviewing and analyzing hundreds of individual stocks, or even dozens of individual funds, you simply need to assess a handful of FOFs.
Professional management. A fund of funds is actively managed by a financial expert. Because fund managers spend so much of their time monitoring funds, they are in a better position than everyday investors to choose winning funds for their FOF portfolio.
Access to alternative investment types. Some FOFs offer access to investment types that may not be available to the average investor. Take venture capital (VC) investments as an example. VC investments can be difficult for individual investors to find, evaluate, and buy into. But a fund of funds may have a clear path to these investments, as well as a FOF manager who has a detailed understanding of the investments.
Mitigated risk. Highly-diversified portfolios typically have lower risk than portfolios that lean too heavily on a single asset class. By investing in a fund of funds, you spread your asset allocation across many different asset classes and categories.
Disadvantages of Fund of Funds Investing
There are also a few potential downsides to be aware of if you’re considering investing in a fund of funds:
Possible lack of liquidity. Depending on the fund, you may be expected to commit to a significant timeframe.
Comparatively high fees. Traditional funds charge fees for the management of the portfolio. A fund of funds adds another layer of fees for the management of the funds that make up the FOF. Because of these multiple management layers, a FOF is sometimes referred to as a multi-manager investment. And compensating all these managers causes investors to pay more in fees for FOF investments than for traditional fund investments.
Possible lack of transparency. While the SEC requires that FOFs disclose fees in a line item called Acquired Fund Fees and Expenses, the reporting of returns for individual funds can lack transparency. Hedge fund FOFs are typically the least transparent, with many hedge fund managers wanting to keep their high net-worth investing strategies confidential.
Watered-down returns. It is possible to over-diversify, allocating too much capital to low-performing stocks. Furthermore, FOFs can create overlapping investments if multiple funds are investing in the same companies. These diversification complications can potentially lead to lower returns.
Types of Fund of Funds
There are a few types of FOFs for investors to be aware of:
Target Date Funds
As the name implies, target date funds are funds with an expected end date. Target date funds are a popular option for retirement accounts because there is a projected date on which you can start pulling from your retirement account without penalty.
Target date funds are set to automatically adjust your asset allocation as you near your target date. In the case of retirement accounts, the further you are from retirement, the more risk you can take with your investments (since you have time to recover from any market downturns). This is a key advantage of investing early because you have the luxury of investing in higher-risk stocks with greater growth potential. But, as you near retirement, you become more interested in protecting your wealth than growing it. So your fund will allocate more of your investment into safer bond funds, and away from riskier stock funds, as the target date approaches.
Target Allocation Strategies
With target allocation strategies, the investor can choose a ratio of stocks to bonds for the asset mix of their FOF. The FOF manager will then choose a mix of stock funds and bond funds to meet that ratio. The manager will also be responsible for periodically rebalancing the portfolio to make sure the FOF still meets the target allocation as the value of the portfolio grows. For example, if stocks are performing well, and bonds are stagnant, the returns from the stocks will skew the portfolio toward being too stock-heavy. So the manager will invest more in bonds to balance the portfolio and bring it back in line with the target allocation.
Hedge Fund of Funds
Hedge funds are traditionally reserved as investments for accredited investors because of their higher-than-normal risk levels and comparatively low transparency.
But a hedge fund of funds can offer nonaccredited investors access to a mix of publicly-traded hedge funds.
Business Development Companies
Business development companies (BDCs) support struggling businesses by lending the capital they need to recover their financial footing. This can be risky for investors because the businesses have been in financial trouble and are in need of funding to bounce back. But the payoff can be substantial if companies are able to pay down their debts and raise their stock price thanks to the cash infusion.
As with REITs (real estate investment trusts), BDCs are required to pay out nearly all their profits to investors via dividends. So BDCs offer passive income potential to risk-tolerant investors.
Common Fee Structures for Fund of Funds
The most common fee structure for FOFs consists of management fees plus carried interest fees. The management fee is a percentage of the total portfolio’s value, and the carried interest fee is a percentage of the interest yielded by the portfolio.
Fees vary by FOF, but the common ranges are
FOF Management Fee: 0.5% to 1%
FOF Carried Interest: 5% to 10%
It’s important to remember that the individual funds the FOF invests in also have fees, which are passed on to the investor.
These fees also vary by fund, but here are the common ranges
Fund Management Fee: 1.5% to 2.5%
Fund Carried Interest: 15% to 25%
Fund of Funds FAQs
There are a few commonly asked questions about FOFs that we’ve not addressed in previous sections. So let’s address them now.
Are FOFs common?
Yes. While other fund types, like mutual funds, ETFs, and index funds are more common, the SEC estimates that around 40% of funds hold an investment in at least one other fund.
How much capital is invested in FOFs?
In a 2020 press release, the SEC estimated fund of funds investments at $2.54 trillion.
Are FOFs regulated by the SEC?
Yes. All pooled-fund investments, including FOFs, are regulated by the SEC. SEC Rule 12d1-4 specifically addresses fund of funds policies.
How do I invest in a FOF?
The easiest way to invest in a FOF is through an investment broker.
Gatsby Investment’s Investing Options for Fund of Funds Managers
While Gatsby Investment does not offer FOF investments to individual investors (our direct offerings are focused on real estate deals with low minimum investments and high return potential), we do accept investments from fund managers.
Our fund of funds investing model allows funds to invest in real estate projects with high-yield potential. Through our short-term real estate flips and developments, you can increase the diversification and flexibility of your fund, or wisely invest your overfunding in comparatively liquid real estate deals.
