By: Michelle Wu

Head of Marketing

August 6, 2024

Today’s investors have more options than ever when it comes to growing their wealth. For example, you can choose to buy individual shares of companies or invest in bonds for a stable and predictable income.

Funds are yet another option. In recent times, these investment vehicles which come in many shapes and forms — including mutual funds, exchange-traded funds (ETFs) and hedge funds — have become quite popular mainly due to their ability to provide diversification. Funds let you pool your money with others to buy a diversified portfolio of assets, thus reducing risk compared to owning just a handful of individual securities.

For investors looking for even more diversification, there exists another investment vehicle known as a fund of funds (FoF). This instrument takes things further by investing in a portfolio composed entirely of other inherently diversified funds. This is just the tip of the iceberg however; FoFs offer a multitude of other benefits for investors. 

Below, we’ll break down how a fund of funds work, the main types, and how to decide whether to include it in your investment strategy. 

Understanding fund of funds

A fund of funds, also sometimes called a multi-manager fund, is an investment vehicle that pools capital from multiple investors and then invests it in a portfolio of other investment funds rather than directly in individual stocks, bonds, or other securities. 

Initially, FoFs primarily invested in mutual funds and hedge funds but have since expanded to include private equity, venture capital, real estate, commodities and other alternative investments. 

As of 2023, the global fund of fund market was valued at US $6.8 billion. This is expected to rise to US $11.6 billion by 2031.

FoFs are available to both individual and institutional investors.  

How a fund of funds works

A fund of funds (FOFs) operates on a limited partnership model comprising two main stakeholders. 

• Fund of fund manager (General Partner): This is an investment manager or management firm that operates and administers the fund. They are responsible for selecting underlying funds, managing the entire portfolio, and ensuring it adheres to its investment strategy and goals. General partners (GPs) employ strict criteria for fund selection, considering factors like past  performance, fund manager expertise, and alignment with the FoF’s investment objectives.
• Investors (Limited Partners): These are the individuals or institutions who contribute capital to the FoF for investment.

Most FOFs also have a governance structure that may include a board of directors and an investment committee. These entities oversee the fund and ensure its operations align with investors’ best interests.

In the United States, the Securities and Exchange Commission (SEC) is the primary regulator of FoFs. It enforces various regulations that ensure FoFs provide adequate disclosure to their investors, adhere to fair trading practices, and maintain appropriate levels of liquidity and risk management. 

The primary goal of a FoF is to achieve diversification by spreading investments across multiple funds, which can help mitigate risk and improve potential returns.

The FoF manager decides on the allocation of assets among different types of underlying funds, which may vary depending on the FoF’s investment objectives, risk tolerance, and market conditions.

Types of fund of funds

Funds of funds can be broadly categorized based on the underlying funds they invest in. Here’s a brief look at the main categories. 

• FoF of mutual funds: These FoFs invest in a diversified portfolio of individual mutual funds, which themselves might be invested in a variety of asset classes like stocks, bonds, and many more. An example of a mutual funds’ FoF is the Vanguard STAR Fund, which invests in a mix of other Vanguard mutual funds.
• FoF of hedge funds: These FoFs invest in a basket of hedge funds. This type of FoF is particularly appealing to investors seeking the sophisticated risk management and high return potential associated with hedge funds, but who don’t want to research, select and monitor individual hedge funds themselves. The Blackstone Group, Black Alternative Investors and Credit Suisse Alternative Funds Solutions are examples of platforms that offer FoF hedge funds. 
• FoF of private equity funds: These FoFs invest in a portfolio of private equity funds, providing access to companies not publicly traded on stock exchanges. These funds typically have a long investment horizon but offer the potential for higher returns. Private equity FoFs may invest in various strategies such as venture capital, growth equity and buyouts. Notable entities that offer private equity FoFs in the US include HarbourVest Partners, AlpInvest Partners and Goldman Sachs AIMs. 
• FoF of commodity funds: These FoFs invest in a basket of commodity-focused funds including those that target energy, precious metals, and agricultural products. 
• FoF of real estate funds: These FoFs invest in a portfolio of real estate investment funds, offering indirect exposure to the real estate market. 
• Multi-asset FoFs: Some FoFs adopt a multi-asset approach, investing in a broad range of underlying funds such hedge funds, mutual funds, commodity funds and many more instead of just one type. 

Additional categorization methods

Beyond underlying funds, FoFs can also be categorized by:

• Investment strategy: Examples include target date funds aimed at a specific retirement date and target allocation funds designed to maintain a specific asset allocation.
• Sector: These FoFs focus on a particular industry sector.
• Geographical region: These FoFs invest in funds focused on specific geographic areas.

Fettered vs. unfettered FoFs

Funds of funds can be further classified as fettered or unfettered:

• Fettered FoFs: These FoFs are restricted to investing in underlying funds managed by the same company or firm that manages the FoF.
• Unfettered FoFs: These FoFs have the flexibility to invest in funds from external firms or managers.

Benefits of fund of funds

Funds of funds offer several advantages for investors. Let’s explore the main ones.  

• Broad diversification: A core advantage of FoFs as mentioned earlier is broad diversification. By investing in a single FoF, you gain exposure not just to multiple asset classes but also multiple investment strategies and fund managers. This structure massively reduces the risk of loss on your investment.
• Access to exclusive investments: FoFs can provide access to investment opportunities that might otherwise be out of reach for individual investors. That includes hedge funds and private equity funds, which often have high minimum investment requirements (sometimes exceeding $5 million). FoFs eliminate this barrier by allowing smaller investors to pool their capital and gain access to these potentially high-reward asset classes.
• Expert management: FoFs offer investors access to the knowledge and expertise of experienced fund managers. These professionals conduct in-depth due diligence, meticulously select high-quality underlying funds, and continuously monitor and rebalance the FoF’s portfolio. This expertise can translate to improved investment outcomes for investors.
• Convenience and simplicity: FoFs simplify the investment process by eliminating the need for individual investors to conduct extensive research and select specific funds. Essentially, FoFs act as a one-stop shop for investors seeking a diversified portfolio without the legwork that comes with it.
• Potential for higher returns: Some FoFs, particularly those that invest in alternative assets like hedge funds or private equity, may offer the potential for higher returns compared to traditional investments like stocks or bonds. However, this also comes with the potential for greater risk.

Disadvantages of fund of funds

While there are many benefits to reap from FoFs as seen, there are also some drawbacks that investors should consider.

• Higher fees: FOFs typically have layered fees that can add up and eat into your returns. These fees include management fees charged by the FoF itself, as well as fees charged by the underlying funds within the portfolio. Carefully evaluate the Total Expense Ratio (TER) of a FoF to understand the full cost of investment.
• Potential for muted returns: The diversification within FOFs can sometimes dampen returns. An FoF invested in a broad range of underlying funds might miss out on the exceptional performance of any single high-performing fund, as these gains may be diluted by lower-performing funds.
• Complexity: The structure of FOFs with multiple layers of investment can make it challenging for investors to fully understand the underlying holdings and assess the overall risk profile of their investment. 
• Liquidity: Some funds of funds like those investing in hedge funds or private equity might have limited liquidity. Investors may not be able to access their capital as quickly or easily as they might need due either due to less frequent redemption opportunities or longer lock-up periods. Be sure to understand the liquidity terms, including redemption windows and any associated penalties or restrictions, before investing in an FoF.

Fund of funds vs direct investments

Direct investments offer greater control over your investment selection and portfolio composition. Going for direct investments also means you avoid the layered fees associated with FoFs. What’s more, some direct investments like publicly traded stocks offer great liquidity compared to some FoFs 

But like any other investment, this approach has its drawbacks. For example, selecting individual investments requires significant research and analysis. In addition, achieving adequate diversification through direct investment requires buying a large number of individual securities.

Ultimately, the better option between the two depends on your individual circumstances and your investment goals. Here are some factors to consider:

• Investment knowledge and experience: Investors with limited investment knowledge or time may benefit from the convenience and expertise offered by FoFs.
• Risk tolerance: Conservative investors may prefer the diversification benefits of FoFs, while those with a higher risk tolerance might consider direct investment.
• Investment objectives: Direct investment may be a better fit for investors with specific investment goals, such as focusing on a particular sector or asset class.

Future trends in fund of funds

The FoF market is constantly evolving. Here are some potential trends that may shape the future of this landscape.

• Technological innovations: Advancements in technology are transforming how FOFs operate. For example, data and artificial intelligence (AI) are streamlining and enhancing the fund selection process. FoF managers can now  leverage these technologies to analyze vast datasets and identify high-performing funds more efficiently.  These technologies also enhance risk management by providing real-time insights into market conditions and portfolio performance.
• Focus on ESG: Environmental, Social, and Governance (ESG) considerations are becoming increasingly important to investors. To cater to this growing demand, new FoFs that prioritize or exclusively focus on sustainable and socially responsible investments are emerging.

Wrapping up: Why are fund of funds an attractive option to investors?

A fund of funds  is a unique investment vehicle that pools capital from individuals and institutions and uses it to invest in a portfolio of other funds like mutual funds, hedge funds and private equity funds. The main benefits of this investment approach include broad diversification, access to exclusive investment opportunities and expert management. 

However, FoFs also come with potential drawbacks, including higher fees, limited liquidity, and even a potential for muted returns if the portfolio is exceedingly diversified. Carefully consider your investment goals, risk tolerance, and the specific features of each FoF before investing. Consulting with a financial advisor can also help you make an informed decision. 

If you’re thinking of incorporating FoFs into your investment strategy, Allvue Systems can be a useful partner. Our powerful fund of funds software provides solutions for fund accounting, portfolio monitoring, investor and investment management, and many more  to help you run your FoF more efficiently and ultimately achieve the best outcomes for you and your investors.

Contact us today to learn more or better yet, request a free demo to see Allvue’s software in action. 

Sources

Securities and Exchange Commision. Fund of Funds: A Small Entity Compliance Guide.  https://www.sec.gov/investment/secg-fund-of-funds

Dakota. The Top 6 Hedge Fund of Funds. https://www.dakota.com/resources/blog/the-top-hedge-fund-of-funds

Market Research Intellect. Global Fund of Fund (FoF) Market. https://www.marketresearchintellect.com/download-sample/?rid=1050833&utm_source=PulseJuly01&utm_medium=031

More About The Author

Michelle Wu

Head of Marketing

Michelle is a dynamic marketing leader with 15+ years of experience in capital markets, fintech, and cybersecurity technology industries. Prior to joining Allvue, Michelle was the Vice President of Product Marketing at SecurityScorecard, a global leader in cybersecurity ratings, and was the Head of Security & Compliance Marketing at Box. Before moving into cybersecurity, she led the Banking & Securities GTM strategy at Intralinks and covered capital markets clients at HSBC. She holds an MSc in Media & Communications from the London School of Economics and a BS in Marketing & Finance from NYU Stern School of Business.