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What is Fund of Funds? Research Team | Posted On Wednesday, April 08,2009, 04:04 PM

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What is Fund of Funds?



What is Fund of Funds?

A "fund of funds" (FoF) is an investment fund that uses an investment approach of holding a portfolio of other investment funds rather than investing directly in shares, bonds or other securities. Fund of funds type of investing is often referred to as multi-manager investment.

A fund of funds is a mutual fund which invests in a group of funds as a substitute of picking specific stocks. These funds of funds have a great demand to investors, because it gives the perception of greater diversification.

There are various kinds of 'fund of funds', each investing in a different type of collective investment scheme (usually one type per FoF). For instance 'Mutual fund' FoF, hedge fund FoF, private equity FoF or investment trusts FoF.

Features of Funds of Funds:

Investing in a shared investment scheme will increase diversity compared to a small investor holding a range of securities directly. Investing in a fund of funds arrangement will achieve even higher diversification.

An investment manager may aggressively manage your investment with a view to selecting the best securities. A FoF manager will try to select one of the best performing funds to invest in based upon the managers historical performance and other factors. If the FoF manager is skillful, this additional level of selection can provide greater strength and take on some of the risk relating to the decisions of a single manager. As in all other kind areas of investing, there are no guarantees for regular returns.

See Also: What You Must Know About Mutual Funds?

Considerations in Fund of Funds:

Management costs for fund of funds are usually higher than those on traditional investment funds because they include fraction of the management fees charged by the underlying funds.

In view of the fact that a fund of funds buys many different funds which themselves invest in many different securities, it is possible for the fund of funds to own the same stock through several different funds and it can be difficult to keep track of the overall holdings.

FoF are often used when investing in hedge funds and private equity funds, as they usually have a high least amount investment level compared to conventional investment funds which precludes many from investing directly. In addition to this, hedge fund and private equity investing is more complicated and highly risk than traditional collective investments. The deficiency of accessibility favors a Funds of funds with a professional manager and built in spread of risk.

Pension funds and other institutions very often invest in funds of hedge funds for part or all of their "alternative asset" programs that is investments other than traditional stock and bond holdings.

See Also: How Mutual Funds Invest Your Money?

Private Equity FoF:

Private equity Funds of funds are funds investing in other private equity funds (i.e., fund of funds, including secondary funds) amounted to 14% of all committed capital in the private equity market.

Fund of Hedge Funds:

A fund of hedge funds is a FoF that invests in a portfolio of different hedge funds to provide broad exposure to the hedge fund industry and to diversify the risks associated with a single investment fund. Funds of hedge funds choose hedge fund managers and construct portfolios based upon those selections. The fund of hedge funds is accountable for hiring and firing the managers in the fund. Some of the funds of hedge funds might have only one hedge fund in it thus lets ordinary investors into a highly-acclaimed fund, or many hedge funds.

Funds of hedge funds usually charge a fee for their services, always in addition to the hedge fund's management and performance fees, which can be 1.5% and 15-30%, respectively. Fees can diminish an investor's profits and potentially reduce the total return below what could be achieved through a less expensive mutual fund or ETF.

While funds of funds conceptually can provide extremely beneficial services for many hedge fund investors, they have been criticized for the significant incremental costs they impose. (The fundamental hedge funds usually charge fees of between 1 and 2% of assets managed and incentive fees of 15–25% of profits generated. The funds of funds usually add additional fees of 1% and 10%, respectively). Over and above, fund-of-funds behavior has often exhibited crowd-following tendencies, suggesting the managers of these funds prefer to match indices rather than seek opportunities.

See Also: How Mutual Funds Work?

The industry has in recent times been criticized by some hedge fund managers for a reputation of holding a short-term view. Some of the hedge funds have even started turning away fund of hedge funds money.

FoF Strategies:

The basic approach for fund of funds is to select mutual funds which are outperforming all of their competitors. The basic judgment is that these funds will continue to outperform regardless of the changes in the market environment.

FoF Fees:

FoF fees can be much greater than the standard fees associated with mutual funds. This is due to the factor that investors will have to pay the fees associated with not only the mutual fund, but also the fees of the actual funds where there dollars are invested. In essence, the investor could be paying double fees since they are aggressively invested in two companies. Some of the larger mutual fund companies have found some methods for getting around these fees by purchasing funds from their own company. Take for instance, an investor can select a fund of funds from Fidelity, which are exclusively made up of Fidelity mutual funds.

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