What Is a Fund of Funds (FOF)?

A Fund of Funds (FOF), also known as a multi-manager investment, is a collective investment fund that allocates capital to various types of funds instead of directly investing in individual securities such as stocks or bonds. Essentially, a FOF’s portfolio comprises diverse underlying portfolios of other funds, offering investors a convenient way to access multiple investment opportunities through a single vehicle.

FOFs typically invest in mutual funds or hedge funds and can be categorized as either “fettered,” confined to investing in funds managed by their own firm, or “unfettered,” allowing investments across the broader market.

How a Fund of Funds (FOF) Works

The strategy behind a Fund of Funds (FOF) is to achieve broad diversification and proper asset allocation by investing across various fund categories within a single portfolio. Depending on the specific FOF type, it can take the form of a mutual fund, hedge fund, private equity fund, or an investment trust, each offering a distinct investment approach.

FOFs serve as a viable option for individual investors seeking exposure to diversified portfolios with varying underlying assets that may otherwise be inaccessible due to high entry barriers, as seen with hedge funds requiring substantial minimum investments or net worth.

Fund of Funds Advantages

Fund of Funds (FOFs) appeal to small investors aiming for enhanced exposure with reduced risks compared to direct securities investments, offering professional wealth management services and expertise.

Investing in FOFs allows individuals with limited capital to access diversified portfolios including assets that are typically exclusive to larger investors, providing an opportunity for broader investment exposure.

Furthermore, FOFs implement a thorough due diligence process, ensuring the credibility and expertise of the fund managers overseeing both the FOF as well as the underlying funds, guaranteeing a robust investment management framework.

Fund of Funds Disadvantages

Despite providing diversification and risk mitigation benefits, FOFs often incur higher fees compared to conventional investment funds, stemming from compounded costs on top of existing fees.

Investors in FOFs face double-layered costs as these funds carry additional expenses, including annual operating expenses, management fees, and operational costs from the underlying funds within the portfolio, potentially impacting overall returns.

Historically, FOFs did not always disclose fees from the underlying funds, a practice that the SEC addressed in 2007 by mandating transparent fee disclosure through the Acquired Fund Fees and Expenses (AFFE) line in FOF prospectuses.

Additionally, selecting proficient fund managers and funds can be challenging, particularly in fettered FOFs, potentially leading to overlapping holdings and reduced diversification benefits.

Pros

• Ultimate in diversification

• Professional management expertise

• Alleviation of risk and volatility

• Exposure to assets usually beyond small investors

Cons

• Additional layer of fees

• Risk of overlap in holdings

• Difficulty in finding qualified managers, funds

Real-World Example for Fund of Funds

Funds of Funds exhibit diverse variations making them challenging to collectively track. One existing benchmark is the Barclay Fund of Funds Index, maintained by Barclay-Hedge, reflecting the average return of reporting FOFs. As of Q1 2022, 156 FOFs displayed an average year-to-date return of 0.33% while the S&P 500 concurrently declined over 7.5%.

Are Funds of Funds Common?

Dedicated Funds of Funds may not be as prevalent as standalone mutual funds or ETFs, yet around 40% of all registered funds have investments in at least one other fund according to the SEC.

How Much Assets Are Invested in Funds of Funds?

The SEC reports that total net assets in mutual funds primarily investing in other mutual funds exceeded $2.54 trillion in 2019, underscoring the substantial investment presence of Funds of Funds.

Are Funds of Funds Regulated by the SEC?

Indeed, akin to other collective investment products, Funds of Funds (FOFs) are subject to regulatory oversight by the SEC, with SEC Rule 12d1-4 establishing guidelines to streamline FOF frameworks. Additionally, transparent disclosure of fees is mandated by the SEC, ensuring clarity and accountability in FOF operations.