What is a Fund of Funds?
A fund of funds (FOF) is one of many types of investment funds which exist in the finance industry. It is also known as a Collective Investment or a Multi-Manager investment fund.
In this article, we discuss what a fund of funds is, the investment strategy used, types of FOF, as well as the pros and cons of this type of investment fund.
What does fund of funds mean?
A fund of funds is a pool of funds invested in other types of funds. This means its portfolio consists of the different portfolios of other funds, the most common being mutual funds or hedge funds.
As certain mutual funds and hedge funds have very high entry levels, some of the FOFs were created for investors with smaller investable assets. Investors who have limited ability to diversify or those who are not that experienced in choosing funds on their own are also attracted to FOFs.
What is a fund of funds investment strategy?
The strategy employed in FOFs is to achieve broad diversification and appropriate asset allocation with investments in a variety of fund categories. All the invested assets are then wrapped into a single portfolio or fund.
Since the assets are other funds, which may already have its own managers, this strategy of investing gave rise to the term ‘multi-manager investment’.
Each FOF may have its own strategy by choosing specific fund types which have their own respective investment strategies. The basic principle behind a fund of funds is for investors to gain broader exposure categories with fewer risks than a direct investment in a multitude of different funds.
FOF portfolio managers use their skill and experience to select the best underlying funds based on past performance and other relevant factors. Thus, return and risk potential depends on the manager’s talent to a certain extent. It is also up to the fund manager to decide the number of funds to achieve its diversification objectives.
Fund of funds example
Andy wants to invest in 3 hedge funds to diversify his risk portfolio. Assuming the minimum investment per fund is S$10 million, he would have to fork out S$30 million.
However, if there is a fund of funds that invests in the underlying of all 3 such funds, Andy can access them with an investment of only S$10 million.
James only has S$5,000 but he wants the exposure of stocks and bonds. At the same time, he wants to limit his risk. Instead of purchasing a very limited number of stocks and bonds, he invests in a mutual fund FOF.
The FOF consists of several different mutual funds that invest in a variety of stocks and bonds. James benefits from the professional management of the FOF but he must pay fees charged by the FOF management company on top of interest for the operating expenses in the underlying fund.
Types of Fund of Funds
They can be classified in two ways:
- Fettered – only able to invest in funds managed by the FOF’s managing company; or
- Unfettered – able to invest in other funds across the market managed by external fund managers
There are different kinds of FOFs. Each type acts on a different investment scheme. It may be structured as a mutual fund, a hedge fund, a private equity fund or an investment trust, depending on its overall investment strategy and assets.
There may also be FOFs which focus on the domestic market and those that focus on the international market. Here is a non-exhaustive list of FOF types:
1. Multi-manager fund of funds
The most common type, its asset base comprises various mutual funds, all of which have a different portfolio concentration. A multi-manager FOF usually has multiple portfolio managers, who each deal with a specific asset present in the mutual fund.
2. Asset allocation or Thematic funds
These FoFs invest in a diverse class of funds that could be asset class focused or thematic focused. The assets range from equity-oriented, debt-oriented or even other alternative strategies such as a crypto-focused.
There has been a rise in thematic FoFs as well, focusing on specific sectors such as for example Tech-Related funds, Artificial Intelligence/Machine Learning oriented funds, Metals & Mining etc. or focusing on latest themes such as ESG funds, green bonds etc.
3. Foreign or International fund of funds
The underlying assets are funds of bonds and shares of global companies. This type of FOF may also invest in funds operating in foreign countries.
4. Fund of Funds ETF
The assets of this type comprise exchange-traded funds. This type may be more susceptible to the volatility of the market because ETFs have a slightly higher risk factor associated with them as they are traded like shares in the stock market.
5. Fund of Funds Private Equity
As the name suggests, this type invests in private equity funds. The asset classes can be specialised on certain industries, market types such as emerging markets, platform companies, and even co-investments.
6. Fund of Funds Venture Capital
It invests in a portfolio of different venture capital funds for access to private capital markets
7. Gold Fund of Funds
This type invests in various forms of gold such as physical gold and gold securities.
8. FX Fund of Funds
This FoF seeks to allocate across various types of FX strategies to profit from various profit factors, diversify risk exposure and to manage overall drawdown.
Fees and expenses of FOFs
An investor who purchases an FOF must pay two tiers of fees. The first is the FOF’s management fees and performance fee. Performance fees are typically lower than those of the individual funds which the FOF invests in. The second tier of fees is a hidden cost incurred by the fees of the individual underlying funds.
Is it good to invest in fund of funds?
The answer to this question depends very much on an investor’s expectations. Both risk and returns from an FOF may be lower than that of an individual hedge fund or unit trust due to the FOF’s nature.
Fund of fund advantages
1. Easy to manage
A significant advantage of investing in FOFs is that it is easy to manage. An investor needs to track only one NAV (Net Asset Value) and a single folio.
2. Diversify risk
Risk is alleviated in two ways: (1) assets and (2) fund manager. FOFs spread the risk of the many assets contained in the funds it invests in.
This also reduces the risk of investing with a single fund manager if an investor were to have only a single fund in his portfolio. If the overall market falls, depending on the composition, the FOF’s performance may take a lesser hit if there are hedging properties or market neutral funds included..
3. Credible fund managers
FOF investment companies are required to verify and check the credibility of their appointed managers. The due-diligence procedure even extends to those managing the underlying funds of the FOF.
In addition to searching for a disciplinary history within the securities industry, the credibility check includes researching the managers’ backgrounds, verifying credentials, and checking references provided by a fund manager of any individual fund that is being considered as an investment.
4. Avenue to invest with less capital
FOFs invest in assets that would be hard to invest individually if one does not have a large capital. Most hedge funds, for example, normally require at least a six-figure investment, making them out-of-reach for the average retail investor.
FOFs can give investors the ability to spread their capital among thousands of stocks with a single purchase. Rather than assuming the risk of selecting a single fund manager, FOFs provide a portfolio of managers through a single investment.
Fund of fund disadvantages
1. Risk of overlap in assets
An FOF buys many funds (which themselves invest in a number of securities). Thus, an FOF may inadvertently end up owning the same kind of assets, or even the same stocks, through the different funds invested under the FOF. This reduces the actual diversification, and in turn may affect returns potential.
In addition to that, because an FOF may invest in hundreds of funds, it may become so diversified that beating the market is impossible. This may cause too much overlap in the underlying funds’ positions.
2. Additional layer of fees
Returns of an FOF may be drastically reduced by investment fees that are typically higher than traditional investment funds. The higher fees of FOFs arise from the compounding of fees on top of fees.
3. Reduced flexibility
The FOF portfolio is curated by the FOF manager, and hence will be subject to the FOF’s specific mandate. Should an investor has a strong preference for its portfolio allocation, FOF may present several restrictions.
4. Difficulty in finding qualified managers and funds
While Singapore has a large pool of fund managers as it is one of the largest financial hubs in Asia, selecting star fund managers is still a challenging task, since historical performance is not a guarantee of future results. The difficulty increases in orders of magnitude especially if the FOF is fettered.
Simply put, a fund of funds (FOF) is a pooled fund which invests in other funds, usually hedge funds or mutual funds. It may be suitable for investors who have less experience and limited capital.
Its main strategy is to achieve broad diversification and minimal risk. However, it tends to have higher expense ratios than regular mutual funds. As with any kind of investment, FOFs are subject to market risks as well. You might wish to consult with an experienced asset management firm first before adding any investment to your portfolio.
Co-Founder, Chief Executive Officer
Haruhito was the Executive Director of Marcuard Heritage Singapore Pte Ltd, a Swiss multi family office. He was instrumental in building up their European and Asian clientele base which comprised of a global network of asset managers, distribution partners, and legal & tax specialists. Prior to that, he held various positions for 10 years in Deutsche Bank where he gained extensive experience in various Asian markets.
Haruhito has been accredited as a Trust and Estate Practitioner (TEP) by STEP, and as a Financial Industry Certified Professional (FICP) by Singapore’s Institute of Banking and Finance. His vision for Salzworth is to steer it to establish multi-asset class portfolios and funds that seek to achieve steady returns for investors.