What is an Investment Fund of Funds vs a Mutual Fund or Individual Securities?

What are Investment Funds of Funds

A Fund of Funds ( “FoF”), or funds of funds, is not a difficult concept to understand if you are familiar with Mutual Funds, or Electronically Traded Funds (ETFs), or hedge funds, or any type fund for that matter. A Fund of Funds is simply a Fund that invests its assets in other funds, rather than investing in individual securities such as stocks, bonds, futures, options, etc. Another name for this type of fund is a Multi Manager Fund or Multi Managed Fund. For example, the ABC Fund of Funds may invest its assets a combination of the Fidelity Magellan Fund, the T. Rowe Price S&P 500 Fund and the Scudder Large Cap Growth Fund. While the Funds of Funds can invest in individual securities, most of its assets are invested in other funds.

What are the Types of Funds of Funds

A FoF can invest in almost any combination of funds and have it technically be a Fund of Funds. The normal types of these funds are:

- Fund of Funds that consist other Mutual Funds

- Hedge fund of funds

- Private equity fund of funds

- Venture capital funds of funds

The individual investor probably will only be exposed to the Mutual fund “FoF”. You might already be invested in one without even knowing it. If you look at your mutual fund’s prospectus and holdings, you may find that the manager is empowered to invest in other funds and the fund holdings might reflect an investment in a mutual fund of the same company. For instance, one of the fidelity funds could have a holding in another fidelity fund. If you look at your 401k investment options, you might find that one of the Fund Options has more than one investment manager. This is especially true in the Balanced Fund Options where there is an Equity (stock) manager and a Bond Manager. If these underlying managers are managing their own funds rather than individual stocks and bonds, then your 401k assets allocated to this Balanced fund are invested in a Fund of Funds.

Why should one Fund invest in other Funds rather than individual Securities?

These are the main reasons for investing in other funds:

Cost – If you are an investment manager and want to invest a portion of the fund assets to match the S&P 500 Index, you could buy all 500 stocks that comprise the Index. Every stock you buy incurs a brokerage commission. There are so many S&P 500 funds in the market that it is simpler and cheaper to just invest this portion of the fund assets in an S&P500 fund. You would now only have 1 security holding instead of 500 holdings, and 1 brokerage commission instead of 500 brokerage commissions.

Diversification- The Fund Manager can achieve greater investment diversification and overall better investment performance by investing in other funds rather than individual securities. For instance, you as the investment manager have a set amount of money to invest in Small Company stocks (small caps) and this amount will allow you to buy 60 different stocks. If you took the same amount of money and bought 10 different mutual funds, which each hold 60 stocks, theoretically, your fund would now be invested in 600 stocks. However, the issue with this is that each of the funds you invest in may hold many of the same stocks, so there could be unintended duplication. This duplication is seen all the time in 401k Plans where the participants are allocating their accounts among various funds. Participants many times spread their assets over many if not all of the investment options thinking that this provides greater asset diversification. For example, your own 401k plan might offer fund options of Large Cap Growth, Large Cap Value, Large Cap Mixed, and a Large Cap S&P 500 Index fund. These are the funds chosen for your plan by the 401k Trustee or 401k Plan Sponsor, usually your employer. If you choose to put some of your 401k assets in all of these fund options, you may think your stock holdings are very well diversified. However, upon further research, you will find that you are actually duplicating many stock holdings. Many of the stocks in the Large Cap Growth fund can also be found in the S&P 500 fund. It is important that you review the holdings of each fund to determine the level of duplication. Essentially, if you attempt to diversify by investing in all the Stock Fund offerings under your 401k plan, instead of only one or two, you may be actually reducing the level of diversification and increasing your risk level unintentionally.

Expenses charged on Top Funds of Funds

Management Fees for Funds of Funds are typically greater than fees charged on traditional investment funds since they include the management fees charged by the underlying funds in addition to the FoF manager’s fees. This is not always true, but normally the fees are higher.

Primary Consideration

An investor needs to fully understand the Investment Objective of the Fund of Funds, and then thoroughly research the underlying funds to ensure there is not a lot of duplication of stock holdings and that the underlying funds fulfill the objectives. A slight alteration in the mix of the underlying funds can greatly change how the overall fund of funds reacts to changing market dynamics.