What are fund of funds (FoFs) and how do they work?

Fund of funds represent one of the most interesting aspects of finance: how multi-layered it can get. For example, exchange-traded funds (ETFs) are pretty good tools to diversify a portfolio, right? Well, how about an ETF of ETFs, i.e. an exchange-traded fund that tracks the performance of other exchange-traded funds?

The same concept can be applied to mutual funds. By definition, a mutual fund is a group of shareholders coming together to invest in a determined market. Funds are very common tools in venture capital, where investors “bet” on the success of a specific business venture, usually a start-up.

In general, mutual funds invest in diversified holdings to reduce risk, though they generally focus on one sector in particular. Interestingly, mutual funds could also invest in… other mutual funds. That is the case of Fund of Funds (FoFs), which we’ll explain in this article.

What are fund of funds and how do they work?

As we said in the introduction, a fund of funds is a financial program that invests in mutual funds. FoFs’ shareholders decide which mutual fund is more interesting to them, or which one serves their strategy better, and decide to invest in it.

Fund of funds don’t have to be “official”. While there are some whose complete business model is to invest in other funds, a FoF can also be a regular mutual fund that happens to have a stake in another one.

Given this very loose definition, it’s no wonder that the Securities Exchange Commission (SEC) estimates that 40% of the US funds are FoFs, just because they hold at least another fund in their portfolio.

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What types of fund of funds exist?

“Professional” fund of funds, i.e. funds whose majority of their portfolio is invested in other funds, are usually divided into four categories:

• Multi-manager fund of funds: this is the most common type of FoF. In this case, the fund of funds is invested only in funds directly managed by the same holding. The FoF, therefore, appoints different managers to direct the many mutual funds present in its portfolio.
• ETF fund of funds: another very common type of FoF, the name is pretty self-explanatory. It is a kind of fund of funds that invests heavily in exchange-traded funds,
• Asset allocation funds: in this case, the FoF’s portfolio comprises different kinds of securities, from debt obligations to equity and precious metals,
• International fund of funds: again a self-explanatory name, these types of FoFs invest in assets from different countries.

What are the advantages and disadvantages of fund of funds?

One obvious advantage of fund of funds is its wide diversification. As Harry Markowitz once famously said: “Diversification is the only free lunch,” referring to a popular notion that in the real world, “there is no free lunch”, i.e. everything comes at a cost.

Indeed, diversification is often considered the best way to make a return on investment, which is why funds of funds are usually very safe assets.

However, investors should keep in mind that with lower risk comes lower rewards. This is another fundamental principle of trading and ensures that FoFs don’t have as high of a reward as normal mutual funds.

Another disadvantage of FoFs is their operating expenses. Every fund retains a percentage on investments, which doubles in the case of fund of funds.

In short, FoFs are safer assets than usual funds but have higher operating expenses and generally yield lower rewards.