Fund of Funds (FOF)

Fund of Funds (FOF)

Key takeaways
* A fund of funds (FOF) invests in other investment funds rather than individual securities to achieve broader diversification and manager access.
* FOFs can smooth volatility and provide access to strategies or managers that may be hard for individual investors to reach.
* Drawbacks include layered fees, potential for diluted returns, complexity, and reduced transparency.

What is a Fund of Funds?

A fund of funds pools investor capital and allocates it across multiple underlying funds (hedge funds, mutual funds, ETFs, private equity, etc.). Instead of holding stocks or bonds directly, an FOF holds shares of other funds, combining the expertise of multiple managers into one vehicle.

How FOFs work

• The FOF manager raises capital, performs due diligence on candidate funds, and constructs an allocation designed to meet the FOF’s objectives.
• FOFs may be actively managed (selecting and rebalancing underlying funds) or built from passive index funds/ETFs (aiming for lower costs while still providing multi-fund exposure).
• Fees are layered: investors pay the FOF’s management fee plus the fees of each underlying fund. Example (illustrative): if an FOF charges a 1% fee and underlying funds average 2%, total fees can materially reduce net returns once all charges are included.
• FOFs can be “fettered” (invest only in funds from the same company) or “unfettered” (free to choose external funds).

Types of FOFs

FOFs are grouped by the asset types or strategies they target:
* Hedge fund FOFs — combine multiple hedge fund strategies for risk/return smoothing.
* Mutual fund FOFs — allocate across active mutual funds.
* ETF/index FOFs — use ETFs/index funds for broader, lower-cost exposure.
* Private equity FOFs — invest in multiple private equity funds to gain access and diversification.
* Sector/region FOFs — focus on specific industries or geographies.
* Real assets/commodities FOFs — combine funds investing in real estate, infrastructure, or commodities.

Advantages

• Diversification: spreads risk across managers, strategies, and asset classes.
• Access: opens opportunities to funds or managers that might be restricted to institutions or high-net-worth investors.
• Professional selection and monitoring: dedicated manager conducts due diligence and ongoing oversight.
• Simplicity: a single investment provides multi-fund exposure and rebalancing.

Disadvantages

• Higher costs: layered management and performance fees can significantly reduce net returns.
• Diluted upside: spreading capital widely can mute the impact of top-performing funds.
• Complexity and opacity: multi-layer structure can obscure exact exposures and increase evaluation difficulty.
• Potential overlap: underlying funds may hold similar positions, reducing diversification benefits.

FOFs vs. Multi-Strategy Funds (MSFs)

Structure
* FOF: invests in multiple external funds; multiple managers.
* MSF: single fund run by one manager or firm that implements multiple strategies internally.

Fees and control
* FOF: typically higher fees because of two fee layers; diversification via multiple managers.
* MSF: often lower fees and centralized control; flexibility to shift capital across strategies more quickly.

Suitability
* FOF: appeals to investors who want diversified manager exposure and are willing to pay for it.
* MSF: appeals to investors seeking diversified strategies with potentially lower fees and tighter operational control.

Considerations for investors

• Investment goals and horizon: match the FOF’s risk/return profile to your objectives (growth, income, stability).
• Fees and net performance: analyze total expense burden (FOF fees + underlying fees + performance fees).
• Due diligence: review the FOF manager’s track record, selection process, liquidity terms, and transparency of holdings.
• Liquidity and minimums: many FOFs, especially those that invest in private funds, have longer lockups and higher minimum investments.
• Overlap and correlation: check for overlapping positions or correlated strategies that could weaken diversification.
• Taxes: additional layers and turnover can complicate tax treatment—review with a tax advisor if needed.
• Regulation: FOF arrangements are subject to securities regulation; in the U.S., rules such as SEC Rule 12d1-4 set conditions and disclosure requirements for fund-of-funds structures.

How FOFs perform in downturns

Diversification across managers and strategies can reduce volatility and cushion losses compared with concentrated holdings. However, correlated market events can still produce significant declines, and high fees will exacerbate net losses.

Can individual investors replicate an FOF?

Yes—investors can build a diversified portfolio of mutual funds and ETFs themselves. Doing so requires time, expertise, and discipline to select, monitor, and rebalance funds; many investors use FOFs for convenience and access instead.

Bottom line

A fund of funds offers a convenient way to obtain multi-manager diversification and access to specialized funds, but these benefits come with higher costs, greater complexity, and potentially diluted returns. Evaluate fee structures, manager quality, transparency, and how the FOF fits your long-term plan before investing.