What Is a Fund of Funds?

Fund of Funds Explained in Less Than 5 Minutes

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A fund of funds is a mutual fund or exchange-traded fund (ETF) that invests in other funds rather than individual securities. By investing in a selection of other mutual funds, ETFs, or hedge funds, a fund of funds provides investors an opportunity to benefit from multiple investment strategies with one product. If a traditional mutual fund gives an investor diversity by holding several stocks, bonds, or other assets, a fund of funds theoretically multiplies that diversity because each fund holds a number of assets.

Let’s look at how funds of funds are structured, their pros and cons, and whether one might be right for your portfolio.

Definition and Examples of a Fund of Funds

A common example of an investment vehicle that employs the fund-of-funds strategy is a target-date fund (TDF). Target-date funds are a common component of employer-sponsored retirement plans, but they also can be purchased directly from a broker.

Through a target-date fund, you identify a time frame that matches yours—say 20 years—and the fund assembles a portfolio of other equity and fixed-income funds that match how aggressively you should be investing. The investment strategy is adjusted to reduce risk as the target date gets closer.

For example, Vanguard offers target-date funds that invest in several other Vanguard funds to create a broadly diversified mix of stocks, bonds, and, in some cases, short-term reserves. Vanguard fund managers gradually adjust the investment mix to become more conservative as the fund’s target date approaches. This is why target-date funds are sometimes called “set-it-and-forget-it” investing.

Total net assets in mutual funds that invest primarily in other mutual funds grew to $2.54 trillion in 2019 from $469 billion in 2008.

  • Alternate name: multimanager investing
  • Acronym: FOF

How a Fund of Funds Works

The manager of a fund of funds assembles a portfolio of other funds rather than purchasing individual stocks, bonds, or other assets. Some FOFs are structured with the portfolio of funds drawn from the same family of funds. These are called fettered funds. A fund of funds that is not restricted to a certain family of funds is called an unfettered fund.

The fund-of-funds structure can layer fees on top of fees. In other words, you may pay the management fees and expense ratio of the fund of funds itself—as well as the fees and expenses of the funds within that fund.

Management fees are an important element to be aware of with any mutual fund, ETF, or hedge fund, as they directly affect the fund’s total return for the investor.

Fettered funds sometimes eliminate the extra fees because you are staying within one family of funds. The cost of the fund of funds is waived—meaning its expense ratio is 0%—and you only pay the costs of the underlying funds.

Pros and Cons of Funds of Funds

Pros
    • Extra diversification
    • Access to multiple professional investment managers
    • Exposure to investment vehicles otherwise out of reach for many investors


Cons
    • Fees layered on top of fees
    • Risk of holdings overlap
    • Difficulty finding funds and fund managers that outperform indexes

Pros Explained

  • Extra diversification: By investing in multiple funds through one product, investors increase diversification and limit their exposure to volatility.
  • Access to multiple professional investment managers: By definition, a fund of funds places the investor’s money in the hands of several investment fund managers.
  • Exposure to investment vehicles otherwise out of reach for many investors: Investing in a fund of funds can allow investors with limited capital to participate in an investment vehicle that may otherwise be unavailable to them, such as a hedge fund. Hedge funds are frequently limited to investors with substantial money to invest, but a fund of hedge funds is available to investors with more modest sums of money.

Cons Explained

  • Fees layered on top of fees: An investor’s total return may be compromised because the fund of funds stacks its own management fees on top of the fees that come with the portfolio of mutual funds that are included in the fund.
  • Risk of holdings overlap: By blending funds operated by several fund managers, an investor may end up holding the same stock through several funds, thereby decreasing the diversification that is sought.
  • Difficulty finding funds and fund managers that outperform indexes: Data from Vanguard shows that more than 50% of mutual fund managers underperform market indexes across a wide range of investment strategies. In many cases, it’s well over 50% that underperform. An investor may be better off assembling a portfolio of index funds, especially given their low expense ratios.

What It Means for Individual Investors

If you like the “set-it-and-forget-it” aspect of a target-date fund, you will appreciate the options that a fund of funds provides. Funds of funds add diversification and reduce volatility, but that doesn’t mean you can skip reading the prospectus.

Management fees and expense ratios, which are important factors for any fund’s return, are particularly important with funds of funds. The potential of layering fees on top of fees could reduce these funds’ performance in your holdings. Read the prospectus carefully.

Key Takeaways

  • A fund of funds invests in other funds (mutual funds, ETFs, or hedge funds) rather than individual securities.
  • Typically, the fund-of-funds strategy increases diversification. However, it risks overlapping an investor’s holdings if multiple fund managers in the portfolio of funds hold the same security.
  • FOFs can provide access to an investment vehicle, such as hedge funds, that otherwise would be unavailable to an investor with a modest sum to invest.
  • Funds of funds often have higher expense ratios and management fees than traditional mutual funds, as they layer their own fee on top of those that already are in the portfolio of funds.