What is a fund of funds?

A fund of funds (FOF) is an investment vehicle that pools money from investors and buys  a portfolio of other investment funds such as mutual funds, exchange-traded funds or hedge funds. A fund of funds can give investors exposure to a wide array of asset classes with less risk by spreading out their investments among hundreds, if not thousands, of assets.

Here’s how a fund of funds works, how they differ from hedge funds, their advantages and disadvantages and how to invest in them.

How does a fund of funds work?

A fund of funds is an investment fund that owns other funds rather than individual securities. The fund may be structured in a number of different ways, as a private equity fund, a hedge fund, an investment fund or even as a mutual fund. In any case, the fund owns other funds and offers investors a convenient way to gain exposure to this set of underlying funds.

Each FOF generally has an objective and investment strategy that guides the funds it invests in. Some FOFs hold a few dozen funds, while others may hold hundreds. Some funds of funds are listed on an exchange and can be traded.

FOFs are professionally managed, meaning they charge a management fee on top of the expenses of the underlying funds. So investors in a fund of funds end up paying two layers of fees.

The difference between hedge funds and fund of funds

A hedge fund generally takes a pool of money from accredited investors and uses a variety of investing tactics including risky, speculative strategies. Hedge funds can be invested in securities or other investments, and are not fully regulated by the SEC if they fall below a certain size. Investor disclosure requirements are also looser when it comes to hedge funds, another reason why hedge funds are typically open only to accredited investors.

A fund of funds, on the other hand, is not limited only to accredited investors. In other words, it’s regulated more closely by the SEC. That means, in general, even a retail investor can invest in a fund of funds containing hedge funds. FOFs can contain mutual funds and exchange-traded funds (ETFs), while hedge funds typically don’t invest in those types of investments.

Instead of individual investments, a fund of funds gathers a group of other funds into an investment vehicle you can buy into.

Pros of a fund of funds

• Diversification. FOFs can provide a diversified portfolio, helping to mitigate risk and volatility. While mutual funds and ETFs are often considered solid choices for diversification, FOFs may offer wider exposure by capturing a larger number of investments through holding multiple funds. Portfolio diversification is a key component of many financial experts’ strategies.

• Access to alternative investments. Retail investors may be able to access investments typically only within reach of accredited investors through FOFs containing hedge funds or other types of alternative investments.
• Professional help choosing funds. Picking which investments funds to invest in can be difficult. FOFs — which are professionally managed — do the work of choosing funds for you. Plus, FOFs can contain hundreds of other funds, an investment that’s hard to duplicate on your own as an investor.

Cons of a fund of funds

• Layers of fees. The biggest drawback to FOFs are the fees that stack up. If a fund invests in mutual funds, investors pay not only the fee for the FOF but also those of every individual underlying mutual fund. For the investor, that means your return must exceed the fee – which may be two or three percent in total – before you start making a profit. Check the fine print on the fees before investing.
• Illiquidity. Not all funds of funds are traded on exchanges, meaning the ones that aren’t may be less liquid. If having quick access to cash is important to you, be sure to find out how trading works for the fund.
• Redundant holdings. If you invest in multiple FOFs, you might be holding the same investment in different FOFs, meaning higher fees for basically the same investments.

Is a FOF the same as a multi-manager?

Yes, the names are used somewhat interchangeably. When someone says, “multi-manager investment,” it’s synonymous with a fund of funds. Think of it this way, each fund within the fund of funds typically has a manager. So, a fund containing multiple other funds will have multiple managers.

How to invest in a fund of funds

To find FOFs to invest in, search for multi-manager investments or portfolios and think about what you’re looking for with your investment. Portfolios are often focused around a certain strategy or risk tolerance and can have objectives such as income generation or a target retirement date. For instance, John Hancock offers a number of multi-manager portfolios that range from moderate to aggressive.

Once you find a FOF you’re interested in, do your research. Check out what funds the fund invests in, and research the investments on Morningstar and other ratings sites. Be sure to read through the fees and expenses, too.

Given the expense, you may find that it makes sense for you to invest in a variety of funds yourself. Here’s how you can get started investing in mutual funds. Other investors looking for low-cost investments with a strong record should check out the best index funds.

Bottom line

A fund of funds can offer diversification and exposure to a variety of otherwise inaccessible types of investments. However, investors need to keep the cost of such funds in clear focus, since a fund of funds may end up charging exorbitant fees that eat into your returns.