A fund of funds (FOF) is an investment vehicle that invests in a portfolio of other investment funds rather than directly in individual securities (stocks, bonds, etc.). FOFs pool investor capital and allocate it across multiple underlying funds—mutual funds, ETFs, hedge funds, private‑equity funds, or combinations—so investors gain multi‑manager exposure and broad diversification through a single investment.
Key takeaways
– FOFs provide diversification across fund managers, strategies and asset classes by investing in other funds.
– They can give access to managers and strategies that are hard for individuals to reach directly.
– The main drawback is multiple layers of fees: fees charged by the FOF plus fees charged by the underlying funds.
– FOFs can be “fettered” (invest only in funds from the same sponsor) or “unfettered” (invest across managers).
– Multi‑strategy funds (MSFs) are similar in goal but use a single manager to implement several strategies rather than investing across multiple external funds.
How funds of funds work
1. Capital is raised from investors into a top‑level FOF vehicle.
2. The FOF manager conducts due diligence and selects underlying funds that match its objectives and risk profile.
3. The FOF invests the pooled capital across those selected funds according to its allocation plan.
4. Investors receive returns (net of fees) based on the performance of the underlying funds and the FOF’s management.
5. The FOF monitors allocations, rebalances, and conducts ongoing due diligence on the underlying managers.
Fees and cost example
FOFs commonly involve two fee layers:
– FeeFOF = management and possibly performance fees charged by the FOF.
– FeeUnderlying = expense ratios, management fees and performance fees charged by each underlying fund.
Example: $10,000 invested in a FOF with a 1% annual FOF management fee plus an average 2% expense ratio charged by the underlying funds:
– FOF fee = 1% × $10,000 = $100/year.
– Underlying funds’ fees (applied to the $9,900 remaining in simple approximation) ≈ 2% × $9,900 ≈ $198/year.
Total ≈ $298/year (this is illustrative; exact math varies if performance fees, hurdle rates and fee bases differ).
Types of FOFs
– Hedge fund FOFs — allocate to multiple hedge funds/strategies (leverage, long/short, arbitrage).
– Mutual fund/ETF FOFs — invest in mutual funds and ETFs (often more transparent, sometimes lower cost).
– Private equity FOFs — invest across private‑equity funds, giving access to buyout, venture, and other private deals.
– Real‑asset FOFs — allocate across real estate, infrastructure funds, commodities funds.
– Multi‑asset FOFs — combine equities, fixed income, alternatives and other strategies to achieve a target risk/return.
Fettered vs unfettered FOFs
– Fettered FOF: invests only in funds managed by the same parent company (can simplify oversight, but may reduce manager selection flexibility and introduce conflicts).
– Unfettered FOF: can pick funds run by any manager (gives greater choice and potential for best‑in‑class selections but requires more rigorous due diligence).
Advantages of investing in a FOF
– Diversification across managers, strategies and asset classes.
– Access to top or closed managers and specialized strategies (particularly in hedge funds and private equity).
– Professional manager selection and monitoring (outsourced manager of managers).
– Simplified investor experience—one account, one statement, consolidated exposure.
– Potential risk reduction if managers’ returns are not highly correlated.
Disadvantages of investing in a FOF
– Higher overall fees due to multiple layers (can materially reduce net returns).
– Risk of diluted returns—good returns by some underlying funds can be offset by weaker ones.
– Potential for overlapping exposures among the underlying funds, reducing diversification benefits.
– Reduced transparency—investor is further removed from the underlying holdings and positions.
– Liquidity constraints if underlying funds are illiquid (private equity or some hedge funds).
– Complexity in due diligence and monitoring.
MSFs (Multi‑Strategy Funds) vs FOFs
– MSF: one fund with a single manager executing multiple strategies internally (one fee layer, unified risk management). Pros: potentially lower fees, faster tactical shifts, centralized oversight. Cons: manager concentration risk—single team must be expert across strategies.
– FOF: invests in multiple independent managers to achieve multi‑strategy exposure (manager diversification). Pros: access to specialist managers, less reliance on one team; Cons: higher fees, potential overlapping positions across managers.
Considerations for investors (practical steps before investing)
1. Define goals and role: Clarify whether the FOF is intended for diversification, alpha generation, alternative exposure, or tactical allocation.
2. Understand the fee structure: Request a full fee schedule (FOF fees + underlying fund fees + performance fees + any administrative costs). Run examples of how fees would affect returns over time.
3. Perform manager due diligence: Review track records, process, team stability, and references. Ask about capacity constraints and how managers behave in drawdowns.
4. Examine overlap and correlation: Request holdings/sector breakdowns of underlying funds to identify unintended concentration.
5. Liquidity and redemption terms: Check lockups, gates, notice periods, and how quickly you can get money back. Private‑market FOFs can be illiquid for many years.
6. Transparency and reporting: Ensure you can get timely NAVs, underlying holdings, and risk metrics.
7. Alignment of interests: Look for meaningful manager investments alongside investors and reasonable performance fee structures.
8. Legal and tax structure: Confirm how distributions, fees and taxes are handled; private funds and offshore vehicles can have complex tax implications.
9. Stress testing: Ask for scenario analysis (market downturns, credit stress) showing how underlying funds might behave and how correlations might change.
10. Exit plan: Know your reasons and conditions for selling—liquidity constraints often mean exits are slower or more costly.
How do FOFs fit into a long‑term investment strategy?
– Role: FOFs can serve as a core diversifier for institutional or high‑net‑worth investors who want exposure to specialized managers or to a blend of strategies without directly selecting many funds.
– Tradeoffs: On a long horizon, benefits from manager diversification and access can compound—but fees also compound against returns. Compare expected net alpha (after fees) vs simpler diversified alternatives (low‑cost ETFs, balanced funds).
– Allocation sizing: Because of fees and potential illiquidity, many investors limit FOF allocations to a portion of the portfolio where manager skill and access justify the cost (e.g., alternatives sleeve or tactical allocation).
Can individual investors create their own fund of funds?
Yes—investors can construct a DIY FOF by:
1. Deciding on an allocation framework (target asset mix or strategy mix).
2. Selecting a small number of funds/ETFs that together provide the desired exposure. Prefer low‑cost index funds/ETFs unless you are intentionally paying for active managers.
3. Monitoring for overlap (holdings, sectors) and rebalancing periodically.
4. Managing costs (choose funds with low expense ratios or exclude expensive underlying funds).
5. Considering tax efficiency and using appropriate account types.
This approach avoids paying an additional manager fee, but transfers manager selection and ongoing diligence responsibilities to you.
Are funds of funds regulated by the SEC?
– It depends on the structure: Mutual‑fund or ETF FOFs that are sold to the public are typically registered with the SEC and subject to mutual fund rules (prospectus disclosure, governance, liquidity rules).
– Private FOFs that invest in hedge funds or private equity are often structured as private placements for accredited or institutional investors and are not registered in the same way; they are subject to anti‑fraud provisions of securities laws and to certain reporting requirements if managers are SEC‑registered investment advisers.
– Underlying funds may themselves be regulated differently (mutual funds vs hedge funds vs private funds). Always review offering documents and regulatory status. (See SEC investor education resources for mutual funds, ETFs and private funds.)
How do economic downturns affect FOF performance?
– Diversification benefit: If underlying managers have low correlations, the FOF may experience lower volatility and smaller drawdowns than many single managers.
– Correlation spike risk: In severe market stress, correlations across asset classes and strategies can rise, reducing the diversification benefit and causing larger simultaneous losses.
– Liquidity and gates: Poor market conditions may trigger redemption restrictions at the underlying level (gates, suspension), which can impede the FOF’s ability to meet investor redemptions.
– Fee drag in down markets: High fixed fees hurt more when returns are low or negative; performance fees can also be charged on some funds, further eroding net returns.
– Manager behavior: Some managers may de‑risk or change strategies under stress, altering expected return patterns.
Practical due diligence checklist (step‑by‑step)
1. Read the offering memorandum/prospectus entirely. Note fees, redemption terms, lockups, conflicts.
2. Request underlying funds’ historical returns, volatility, max drawdowns and correlation matrices.
3. Verify manager backgrounds, tenure, turnover and key‑person risks.
4. Ask for a list of underlying funds and recent holdings to check overlap.
5. Request stress‑test scenarios and liquidity plans for stressed markets.
6. Model net expected returns after fees under several scenarios (base case, down 20%, up 20%).
7. Confirm custody and valuation policies—are underlying assets priced frequently and independently?
8. Clarify tax treatment of distributions and gains.
9. Consult a fiduciary adviser or attorney if the FOF is private or complex.
10. Start small and monitor performance, fees and any changes in allocation/strategy.
Practical steps to build a DIY fund of funds (low‑cost approach)
1. Define objectives: risk target, time horizon, role in portfolio.
2. Choose broad building blocks: e.g., total‑market equity ETF, international equity ETF, aggregate bond ETF, real‑asset ETF, alternative/hedge‑fund‑style ETF if desired.
3. Allocate across those funds to meet targets (e.g., 50% equities, 35% fixed income, 15% alternatives).
4. Avoid overlap by checking sector/holding exposures—use tools from broker platforms.
5. Rebalance at fixed intervals (quarterly or annually) or when allocations drift beyond thresholds.
6. Keep an eye on costs—prefer funds with low expense ratios and be mindful of trading commissions/taxes.
7. Document the strategy and rules for fund replacements or manager changes.
The bottom line
Funds of funds can deliver meaningful diversification, manager access and simplified exposure to multiple strategies. They are especially useful for investors seeking access to specialized or closed managers, and for institutions wanting centralized manager selection. However, the extra layer(s) of fees, potential for overlapping exposures and reduced transparency mean investors must carefully weigh net expected benefits against lower‑cost alternatives. Diligent fee analysis, robust due diligence of the FOF manager and underlying funds, and a clear understanding of liquidity and tax consequences are essential before investing.
Selected sources and further reading
– Investopedia — “Fund of Funds (FOF)” (Theresa Chiechi). https://www.investopedia.com/terms/f/fundsoffunds.asp
– U.S. Securities and Exchange Commission — Investor.gov resources on mutual funds & ETFs. https://www.investor.gov/introduction-investing/investing-basics/investment-products/mutual-funds-and-exchange-traded-funds
– SEC — “Investor Bulletin: Hedge Funds” (overview of private funds and investor considerations). https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_hedgefunds
If you want, I can:
– Run a fee‑impact calculator for a specific FOF fee + underlying fees and show projected net returns over 5–10 years.
– Create a template checklist for assessing a particular FOF (questions to ask the manager and documents to request).
,
What Is a Fund of Funds (FOF)?
A fund of funds (FOF) is an investment vehicle that invests in a portfolio of other investment funds rather than directly in individual securities (stocks, bonds, etc.). FOFs pool investor capital and allocate it across multiple underlying funds—mutual funds, ETFs, hedge funds, private‑equity funds, or combinations—so investors gain multi‑manager exposure and broad diversification through a single investment.
Key takeaways
– FOFs provide diversification across fund managers, strategies and asset classes by investing in other funds.
– They can give access to managers and strategies that are hard for individuals to reach directly.
– The main drawback is multiple layers of fees: fees charged by the FOF plus fees charged by the underlying funds.
– FOFs can be “fettered” (invest only in funds from the same sponsor) or “unfettered” (invest across managers).
– Multi‑strategy funds (MSFs) are similar in goal but use a single manager to implement several strategies rather than investing across multiple external funds.
How funds of funds work
1. Capital is raised from investors into a top‑level FOF vehicle.
2. The FOF manager conducts due diligence and selects underlying funds that match its objectives and risk profile.
3. The FOF invests the pooled capital across those selected funds according to its allocation plan.
4. Investors receive returns (net of fees) based on the performance of the underlying funds and the FOF’s management.
5. The FOF monitors allocations, rebalances, and conducts ongoing due diligence on the underlying managers.
Fees and cost example
FOFs commonly involve two fee layers:
– FeeFOF = management and possibly performance fees charged by the FOF.
– FeeUnderlying = expense ratios, management fees and performance fees charged by each underlying fund.
Example: $10,000 invested in a FOF with a 1% annual FOF management fee plus an average 2% expense ratio charged by the underlying funds:
– FOF fee = 1% × $10,000 = $100/year.
– Underlying funds’ fees (applied to the $9,900 remaining in simple approximation) ≈ 2% × $9,900 ≈ $198/year.
Total ≈ $298/year (this is illustrative; exact math varies if performance fees, hurdle rates and fee bases differ).
Types of FOFs
– Hedge fund FOFs — allocate to multiple hedge funds/strategies (leverage, long/short, arbitrage).
– Mutual fund/ETF FOFs — invest in mutual funds and ETFs (often more transparent, sometimes lower cost).
– Private equity FOFs — invest across private‑equity funds, giving access to buyout, venture, and other private deals.
– Real‑asset FOFs — allocate across real estate, infrastructure funds, commodities funds.
– Multi‑asset FOFs — combine equities, fixed income, alternatives and other strategies to achieve a target risk/return.
Fettered vs unfettered FOFs
– Fettered FOF: invests only in funds managed by the same parent company (can simplify oversight, but may reduce manager selection flexibility and introduce conflicts).
– Unfettered FOF: can pick funds run by any manager (gives greater choice and potential for best‑in‑class selections but requires more rigorous due diligence).
Advantages of investing in a FOF
– Diversification across managers, strategies and asset classes.
– Access to top or closed managers and specialized strategies (particularly in hedge funds and private equity).
– Professional manager selection and monitoring (outsourced manager of managers).
– Simplified investor experience—one account, one statement, consolidated exposure.
– Potential risk reduction if managers’ returns are not highly correlated.
Disadvantages of investing in a FOF
– Higher overall fees due to multiple layers (can materially reduce net returns).
– Risk of diluted returns—good returns by some underlying funds can be offset by weaker ones.
– Potential for overlapping exposures among the underlying funds, reducing diversification benefits.
– Reduced transparency—investor is further removed from the underlying holdings and positions.
– Liquidity constraints if underlying funds are illiquid (private equity or some hedge funds).
– Complexity in due diligence and monitoring.
MSFs (Multi‑Strategy Funds) vs FOFs
– MSF: one fund with a single manager executing multiple strategies internally (one fee layer, unified risk management). Pros: potentially lower fees, faster tactical shifts, centralized oversight. Cons: manager concentration risk—single team must be expert across strategies.
– FOF: invests in multiple independent managers to achieve multi‑strategy exposure (manager diversification). Pros: access to specialist managers, less reliance on one team; Cons: higher fees, potential overlapping positions across managers.
Considerations for investors (practical steps before investing)
1. Define goals and role: Clarify whether the FOF is intended for diversification, alpha generation, alternative exposure, or tactical allocation.
2. Understand the fee structure: Request a full fee schedule (FOF fees + underlying fund fees + performance fees + any administrative costs). Run examples of how fees would affect returns over time.
3. Perform manager due diligence: Review track records, process, team stability, and references. Ask about capacity constraints and how managers behave in drawdowns.
4. Examine overlap and correlation: Request holdings/sector breakdowns of underlying funds to identify unintended concentration.
5. Liquidity and redemption terms: Check lockups, gates, notice periods, and how quickly you can get money back. Private‑market FOFs can be illiquid for many years.
6. Transparency and reporting: Ensure you can get timely NAVs, underlying holdings, and risk metrics.
7. Alignment of interests: Look for meaningful manager investments alongside investors and reasonable performance fee structures.
8. Legal and tax structure: Confirm how distributions, fees and taxes are handled; private funds and offshore vehicles can have complex tax implications.
9. Stress testing: Ask for scenario analysis (market downturns, credit stress) showing how underlying funds might behave and how correlations might change.
10. Exit plan: Know your reasons and conditions for selling—liquidity constraints often mean exits are slower or more costly.
How do FOFs fit into a long‑term investment strategy?
– Role: FOFs can serve as a core diversifier for institutional or high‑net‑worth investors who want exposure to specialized managers or to a blend of strategies without directly selecting many funds.
– Tradeoffs: On a long horizon, benefits from manager diversification and access can compound—but fees also compound against returns. Compare expected net alpha (after fees) vs simpler diversified alternatives (low‑cost ETFs, balanced funds).
– Allocation sizing: Because of fees and potential illiquidity, many investors limit FOF allocations to a portion of the portfolio where manager skill and access justify the cost (e.g., alternatives sleeve or tactical allocation).
Can individual investors create their own fund of funds?
Yes—investors can construct a DIY FOF by:
1. Deciding on an allocation framework (target asset mix or strategy mix).
2. Selecting a small number of funds/ETFs that together provide the desired exposure. Prefer low‑cost index funds/ETFs unless you are intentionally paying for active managers.
3. Monitoring for overlap (holdings, sectors) and rebalancing periodically.
4. Managing costs (choose funds with low expense ratios or exclude expensive underlying funds).
5. Considering tax efficiency and using appropriate account types.
This approach avoids paying an additional manager fee, but transfers manager selection and ongoing diligence responsibilities to you.
Are funds of funds regulated by the SEC?
– It depends on the structure: Mutual‑fund or ETF FOFs that are sold to the public are typically registered with the SEC and subject to mutual fund rules (prospectus disclosure, governance, liquidity rules).
– Private FOFs that invest in hedge funds or private equity are often structured as private placements for accredited or institutional investors and are not registered in the same way; they are subject to anti‑fraud provisions of securities laws and to certain reporting requirements if managers are SEC‑registered investment advisers.
– Underlying funds may themselves be regulated differently (mutual funds vs hedge funds vs private funds). Always review offering documents and regulatory status. (See SEC investor education resources for mutual funds, ETFs and private funds.)
How do economic downturns affect FOF performance?
– Diversification benefit: If underlying managers have low correlations, the FOF may experience lower volatility and smaller drawdowns than many single managers.
– Correlation spike risk: In severe market stress, correlations across asset classes and strategies can rise, reducing the diversification benefit and causing larger simultaneous losses.
– Liquidity and gates: Poor market conditions may trigger redemption restrictions at the underlying level (gates, suspension), which can impede the FOF’s ability to meet investor redemptions.
– Fee drag in down markets: High fixed fees hurt more when returns are low or negative; performance fees can also be charged on some funds, further eroding net returns.
– Manager behavior: Some managers may de‑risk or change strategies under stress, altering expected return patterns.
Practical due diligence checklist (step‑by‑step)
1. Read the offering memorandum/prospectus entirely. Note fees, redemption terms, lockups, conflicts.
2. Request underlying funds’ historical returns, volatility, max drawdowns and correlation matrices.
3. Verify manager backgrounds, tenure, turnover and key‑person risks.
4. Ask for a list of underlying funds and recent holdings to check overlap.
5. Request stress‑test scenarios and liquidity plans for stressed markets.
6. Model net expected returns after fees under several scenarios (base case, down 20%, up 20%).
7. Confirm custody and valuation policies—are underlying assets priced frequently and independently?
8. Clarify tax treatment of distributions and gains.
9. Consult a fiduciary adviser or attorney if the FOF is private or complex.
10. Start small and monitor performance, fees and any changes in allocation/strategy.
Practical steps to build a DIY fund of funds (low‑cost approach)
1. Define objectives: risk target, time horizon, role in portfolio.
2. Choose broad building blocks: e.g., total‑market equity ETF, international equity ETF, aggregate bond ETF, real‑asset ETF, alternative/hedge‑fund‑style ETF if desired.
3. Allocate across those funds to meet targets (e.g., 50% equities, 35% fixed income, 15% alternatives).
4. Avoid overlap by checking sector/holding exposures—use tools from broker platforms.
5. Rebalance at fixed intervals (quarterly or annually) or when allocations drift beyond thresholds.
6. Keep an eye on costs—prefer funds with low expense ratios and be mindful of trading commissions/taxes.
7. Document the strategy and rules for fund replacements or manager changes.
The bottom line
Funds of funds can deliver meaningful diversification, manager access and simplified exposure to multiple strategies. They are especially useful for investors seeking access to specialized or closed managers, and for institutions wanting centralized manager selection. However, the extra layer(s) of fees, potential for overlapping exposures and reduced transparency mean investors must carefully weigh net expected benefits against lower‑cost alternatives. Diligent fee analysis, robust due diligence of the FOF manager and underlying funds, and a clear understanding of liquidity and tax consequences are essential before investing.
Selected sources and further reading
– Investopedia — “Fund of Funds (FOF)” (Theresa Chiechi). https://www.investopedia.com/terms/f/fundsoffunds.asp
– U.S. Securities and Exchange Commission — Investor.gov resources on mutual funds & ETFs. https://www.investor.gov/introduction-investing/investing-basics/investment-products/mutual-funds-and-exchange-traded-funds
– SEC — “Investor Bulletin: Hedge Funds” (overview of private funds and investor considerations). https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_hedgefunds
If the business want, I can:
– Run a fee‑impact calculator for a specific FOF fee + underlying fees and show projected net returns over 5–10 years.
– Create a template checklist for assessing a particular FOF (questions to ask the manager and documents to request).