What's the Gist of a Fund of Funds (FOF)?
Investment Strategy Explanation: Understanding Fund of Funds (FOF) Operations
A Fund of Funds (FOF) is a type of investment vehicle that throws cash into a whole array of other investment funds instead of diving directly into stocks, bonds, or individual securities. This multi-manager approach gives investors more diversity and access to the expertise of other skilled fund managers.
Over the years, FOFs have grown popular among institutional investors such as pension funds and endowments who aim to spread risk and boost profits. However, these funds have a slightly sketchy reputation due to the bonus layers of fees they come with.1
Ready to dive deeper into how FOFs work, their potential merits, and potential pitfalls? Let's get to it!
Taking a Closer Look at FOFs
The idea behind FOFs is about combining various hedge fund strategies into a single portfolio. This blend is believed to help achieve higher returns with less risk compared to investing in individual funds by themselves. This diversification strives to tame the volatility often found in fund investments, offering a steadier path to possible gains. Apart from hedge funds, FOFs can be found for a variety of strategies, including exchange-traded, mutual, private equity, and other funds.
FOFs work by collecting capital from investors and then allocating it into underlying funds. For the most part, the managers choose these funds based on their performance, quality of management, and strategy.2
In the past, FOFs mainly focused on actively managed hedge funds. But times have changed, and newer FOFs now invest in more passive indexes and exchange-traded funds (ETFs). These passive FOFs aim to give investors exposure to a broad range of asset classes and investment strategies at a lower cost compared with actively managed FOFs. There's still some active management involved at the FOF level, though, because there's a need to pick those indexes or ETFs that align with the FOF's investment goals and risk profile.
When it comes to FOF fees, they usually involve two layers: the fees charged by the underlying funds and the fees imposed by the FOF managers. For example, an investor putting $10,000 in a FOF with a 1% management fee and underlying funds with a total fee of 2% could see annual fees amounting to $298 ($100 for the FOF and $198 for the underlying funds after the first fee).3
FOF Types: What You Need to Know
FOFs give investors access to a diversified portfolio of funds via a single investment. By pooling capital and spreading it across various underlying funds, FOFs offer professional management, diversity, and access to strategies or managers that might otherwise be unreachable for individual investors.
FOFs come in various shapes and sizes, each designed for different investor needs, risk preferences, and investment objectives. Here's a rundown of the main types of FOFs. Remember, thorough due diligence is crucial before throwing your hard-earned cash into any FOF.
The Benefits and Drawbacks of Investing in FOFs
Perks of Investing in a FOF
- Diversification: FOFs offer exceptional diversification through investing in multiple underlying funds, spreading risk across different asset classes and investment strategies.
- Professional Management: Professional fund managers make decisions based on due diligence, selecting top-performing funds, continuously monitoring, and rebalancing the portfolio.
- Simplified Investment Process: FOFs bundle multiple funds into a single investment vehicle, making portfolio management more convenient for investors.
Troubles with FOFs
- Higher Expenses: FOFs involve higher costs due to the multiple layers of fees, which can eat into overall returns.
- Potential Dilution of Returns: The broad exposure of FOFs can lead to weaker returns since high-performing assets are offset by lower-performing ones.
- Complexity: Understanding and evaluating FOFs can be complex due to their multilayered nature. Investors need to consider not just the strategy of the FOF but also the underlying funds' strategies and performance, making it difficult to assess risks.
- Opaque Nature of Investment: FOFs are less transparent than other investment options, which can make it tough for investors to fully comprehend where their money is invested.
The Bottom Line
FOFs offer a diversified investment strategy by pooling various funds, providing access to exclusive prospects and professional management, but they come with higher costs and the potential for diluted returns. Understanding fees, conducting thorough research, and considering how FOFs align with your long-term investment goals are crucial. Despite their complexity, FOFs can be a valuable addition to a well-rounded investment portfolio.
Sources
- "Retail Investment in Hedge Funds: A Review of the Current Landscape," Financial Times, accessed February 27, 2023, https://www.ft.com/content/978a5c70-294a-11e8-af41-32e9165ddec2
- "Fund of Funds," Investopedia, accessed February 27, 2023, https://www.investopedia.com/terms/f/fundoffunds.asp
- "How Do Funds of Funds Work?" Morningstar, accessed February 27, 2023, https://www.morningstar.com/articles/991724/how-do-funds-of-funds-work
- "Types of Funds of Funds," Investopedia, accessed February 27, 2023, https://www.investopedia.com/terms/t/typesoffundsoffunds.asp
- "What's the Difference Between a Fund of Funds and a Multi-Strategy Fund?" Janus Henderson Investors, accessed February 27, 2023, https://www.janushenderson.com/our-thinking/whats-the-difference-between-a-fund-of-funds-and-a-multi-strategy-fund/
- "Fund of Funds Rule 12d1-4," U.S. Securities and Exchange Commission, accessed February 27, 2023, https://www.sec.gov/rules/final/2018/ic-32918.htm
- "How Are Funds of Funds Regulated in the U.S.?" Investopedia, accessed February 27, 2023, https://www.investopedia.com/ask/answers/10/how-funds-funds-regulated.asp
- "Effect of Recessions on the Performance of Funds of Funds," Investopedia, accessed February 27, 2023, https://www.investopedia.com/ask/answers/08/effect-of-recessions-on-the-performance-of-funds-of-funds.asp
- In the world of finance, Fund of Funds (FOF) serves as an investment vehicle that channels resources into an assortment of other funds, including exchange-traded, mutual, private equity, and hedge funds.
- The multi-manager approach of FOFs offers investors an expanded array of opportunities, minimizing risk by diversifying investments across different strategies and asset classes.
- Venture capital funds can also be part of FOFs' investment portfolio, providing exposure to high-growth startups and early-stage businesses.
- FOFs actively manage trading within their investment pool, leveraging their expertise to select high-performing funds and adjust portfolios based on market conditions.
- Some FOFs have started to invest in Decentralized Finance (defi) projects, seeking opportunities in blockchain-based financial services and providing liquidity to the burgeoning defi ecosystem.
- Institutional investors, including pension funds and endowments, prefer FOFs for their ability to cater to various preferences within an investment framework, offering a more tailored approach to finance and investing for their businesses.
