Fund of Funds (FOF) Explained: How It Works, Pro & Cons, Example

What Is a Fund of Funds (FOF)?

A fund of funds is a pooled investment fund that invests in other funds. Its portfolio contains different underlying portfolios of other funds, replacing direct investments in bonds, stocks, and securities.

FOFs invest in mutual funds or hedge funds, classified as "fettered" (investing in funds managed by the FOF’s managing company) or "unfettered" (investing in funds across the market).

Key Takeaways

• A fund of funds (FOF) is a pooled fund that invests in other funds.
• FOFs usually invest in hedge funds or mutual funds.
• The FOF strategy aims for broad diversification and minimal risk.
• FOFs have higher expense ratios than regular mutual funds.

How a Fund of Funds (FOF) Works

The FOF strategy aims for broad diversification and appropriate asset allocation with investments in various fund categories wrapped into one portfolio.

There are different types of FOFs, each with a unique investment scheme. FOFs can be structured as mutual funds, hedge funds, private equity funds, or investment trusts. They can be fettered or unfettered, depending on their investment in portfolios managed by one company or external funds managed by other managers from different companies.

Fund of Funds Advantages

FOFs attract small investors seeking exposure with fewer risks than direct securities or individual funds. They provide professional wealth management services and expertise.

FOFs allow investors with limited capital to access diversified portfolios with different underlying assets often out of reach for retail investors. For example, hedge funds typically require high minimum investments or minimum net worth requirements, or both.

FOFs require a formal due-diligence procedure for their fund managers, checking their backgrounds and ensuring credentials in the securities industry.

Fund of Funds Disadvantages

FOFs provide diversification and less exposure to market volatility, but higher fees compared to traditional investment funds may reduce returns. Fees compound on top of fees.

A FOF carries an annual operating expense, management fees, and operating costs. Investors essentially pay double as underlying funds in the FOF also have their costs and fees.

Fund prospectuses didn’t always include underlying fund fees, but since January 2007, the SEC requires the disclosure of those fees in a line called Acquired Fund Fees and Expenses (AFFE).

A FOF might charge annual management fees of 0.5% to 1%, investing in funds with another 1% management fee. As a result, investors pay up to 2%. After allocating fees and taxes, FOF returns may be lower compared to single-manager funds.

Picking good fund managers and funds can be difficult, especially if the FOF is fettered. Overlapping holdings reduce actual diversification.

• Ultimate diversification
• Professional management expertise
• Alleviation of risk and volatility
• Access to assets beyond small investors
• Additional layer of fees
• Risk of overlap in holdings
• Difficulty in finding qualified managers and funds

Real-World Example for Fund of Funds

Funds of funds can be hard to track and compare as a group, but the Barclay Fund of Funds Index measures the average return of all FOFs reporting into the company database. As of Q1 2022, 156 FOFs yielded an average return of 0.33% year-to-date, while the S&P 500 lost over 7.5%.

Are Funds of Funds Common?

Dedicated FOFs may be less common than standalone mutual funds or ETFs, but approximately 40% of all registered funds hold an investment in at least one other fund according to the SEC.

How Much Assets Are Invested in Funds of Funds?

In 2019, total net assets in mutual funds primarily investing in other mutual funds reached over $2.54 trillion, according to the SEC.

Are Funds of Funds Regulated by the SEC?

Yes, like all other pooled investment products, FOFs are overseen by the SEC. SEC Rule 12d1-4, updated in 2020, provides a consistent framework for FOF arrangements. The SEC also requires FOFs to transparently disclose their fees.