Sometimes known as a multi-manager investment, a fund of funds is an investment fund made up of a portfolio that contains different portfolios of other funds. In other words, it is a pooled investment fund that acts as an alternative to investing directly in securities such as stocks and bonds.
Most FOFs invest in hedge funds or mutual funds, and are described as ‘fettered’ or ‘unfettered’. The difference is the following:
A fettered FOF can only invest in funds managed by the FOF’s managing company
An unfettered FOF can invest in funds from anywhere in the market
How does a fund of funds work?
The key to a FOF investment is that it pulls a diverse but appropriate set of investments together within one portfolio. This allows assets to be allocated across a wide range of fund categories.
As well as being either fettered or unfettered, a fund of funds might be structured as a hedge fund, private equity fund, investment trust or mutual fund. A well-managed fund of funds diversifies the investment as much as possible while minimising the risk involved.
What is the appeal of a fund of funds?
If you’re a small investor looking to maximise the scope of your investment, then a FOF can do this without the risks attached to other forms of investment, such as in individual funds or directly in securities. It also means that the investment will enjoy the expertise and experience offered by the professional wealth experts in charge of managing it.
How can a FOF maximise the funds invested?
If your capital is limited, then a fund of funds investment enables you to invest your money in diversified portfolios containing assets that would usually be out of your reach. Most hedge funds, for example, have rules that state that the minimum investment has to be a six-figure sum, or that the investor has to have a minimum – and substantial – net worth. Using a FOF gets around such requirements.
The pros and cons of a fund of funds
It enables huge diversification relative to the investment being made
It offers the reassurance of professional wealth management expertise
It removes much of the risk associated with market or individual asset volatility
It enables smaller investors to consider more expensive assets
FOFs involve an additional layer of fees you pay to the fund management
Some of the assets in a fund of funds may overlap with assets you already hold
It can be difficult to identify the right manager and/or fund of sufficient quality to support investment
How does a fund of funds fee structure work?
The biggest drawback of investing in a fund of funds is that the profits you can make will be diminished to a degree by the fee structure, which involves paying multiple levels of fees. The fact that the fees pile one on top of the other means that a FOF is going to cost more to run than a traditional investment fund.
As well as an annual operating expense, a fund of funds comes with management fees and operating costs. The extra paid by FOF investors is driven by the fact that each of the individual funds contained with the overall FOF will charge its own costs and fees.
In simple terms, the fund of funds itself could charge an annual management fee of 1%, with the underlying funds charging their own 1% management fee. This raises the overall cost up to 2% per year, which will eat into any returns.
We can help
If you’d like to learn more about the pros and cons of investing in a fund of funds then take a look at the expert advice offered by GoCardless. In addition to our investment expertise you can find out how GoCardless can help you with ad hoc payments or recurring payments.