Fund of Funds

What is a Fund of Funds?

A Fund of Funds (FoF) is an investment vehicle bundles together multiple investment funds, giving investors a diversified portfolio with just one investment. It's a practical choice for those who want to spread their investments across different asset types under the guidance of expert fund managers, without concerning themselves with due diligence and monitoring of multiple investment funds. 

In a fund of funds, you're not investing directly into stocks or bonds but into a collection of mutual funds, hedge funds, private equity funds, or real estate funds. In this sense, it is similar to a mutual fund or an index fund, except that instead of owning a basket of assets such as stocks or bonds, you are owning a basket of “baskets”—that is, of other funds. In this way, you are at least two degrees removed from the underlying assets you own.

Why Do Fund of Funds Exist?

At first glance, the concept of a Fund of Funds (FoFs) may seem unnecessary. Why would an investor choose a fund that invests in other funds rather than directly selecting individual investments? The answer lies in the unique advantages that fund of funds offer.

First, fund of funds offer easy diversification and professional management, ideal for those with less capital. Second, they provide entry into niche markets and strategies typically inaccessible to individual investors. Third, they streamline investing by managing due diligence, compliance, and maintenance, delivering convenience and expertise not easily matched by direct investing.

Advantages and Disadvantages of Fund of Funds

While Funds of Funds (FoFs) have a role to play in investing, it’s important to understand their pros and cons.

Advantages

• Diversification: FoFs inherently provide a broad diversification by investing in a variety of funds, each with its own strategy and asset allocation. This can dilute risk as the performance of the fund is not tied to the success of a single investment.

• Access to Expertise: Investors benefit from the expertise of multiple fund managers. FoFs often include funds that may be out of reach for the average investor due to high minimum investment requirements. That being said, investors in FoFs would still not have direct access to the expertise of the managers of the underlying funds. Instead, they would need to rely on the FoF manager’s expertise in selecting and managing those underlying funds.

• Time and Cost Efficiency: By investing in a FoF, investors can save the time and effort that would otherwise be spent researching and managing multiple fund investments. It also allows investors to achieve economies of scale in terms of transaction costs.

• Risk Management: Professional FoF managers can actively monitor and adjust the portfolio of underlying funds, which may be prohibitively costly or time-consuming for individual investors to do on their own.

Disadvantages

• Higher Expense Ratios: FoFs tend to have higher fees due to the additional layer of management. Investors pay not only the management fees of the fund of funds but also the fees of the underlying funds.

• Diluted Returns: While diversification can reduce risk, it can also dilute the returns. High-performing funds can have their impact lessened within the broader mix of the FoF portfolio.

• Complexity: The multi-layered structure can make it harder for investors to understand where their money is being invested and to accurately assess the risk and return profile of the fund.

• Potentially Less Control: Investors in fund of funds may have less control over the selection of underlying funds and may be invested in funds they would not have chosen individually.

The balance between the benefits and limitations of fund of funds is delicate and requires investors to carefully consider their individual investment goals, risk tolerance, and the track record of the FoF managers.

Real-World Examples of Fund of Funds

The role of Fund of Funds (FoFs) in the investment sector is highlighted by the existence of large, influential players in the market. Here are three of the most prominent FoFs:

• Blackstone Alternative Asset Management (BAAM): BAAM is a significant player in hedge fund investments, creating funds that invest across multiple hedge fund strategies. These strategies may include quantitative approaches, event-driven situations, and global macro trends.

• Goldman Sachs Asset Management (GSAM): The Multi-Manager Alternatives Fund by GSAM is a fund of funds that diversifies investor capital among several alternative investment strategies. This fund typically allocates to strategies such as distressed debt, equity long-short, and tactical trading.

• HarbourVest Partners: HarbourVest offers FoFs that invest in various sectors of the private equity market, including technology startups, healthcare firms, and industrial companies through venture capital and growth equity funds. They also invest in buyout funds, which may focus on acquiring control positions in more mature companies, and mezzanine funds, which provide subordinated debt with equity features.

These institutions serve as prime examples of how fund of funds can operate at a significant scale, with GSAM alone overseeing over $1 trillion of assets as of June 2018.

Types of Fund of Funds

FoFs can be categorized based on their investment approach as fettered or unfettered—fettered FoFs invest only in funds managed by the parent investment company, ensuring a consistent investment philosophy; unfettered FoFs, on the other hand, invest in funds across different management companies. Moreover, FoFs further diversify across three main categories based on the nature of their underlying portfolio holdings:

1. Strategy-Specific Fund of Funds:

• Hedge Fund of Funds: Invests in a collection of hedge funds, leveraging varied strategies like long-short equity, global macro, and market neutral for risk-adjusted returns.

• Private Equity Fund of Funds: Pools investments in multiple private equity funds that specialize in ventures such as capital, buyouts, and mezzanine financing, affording access to private market segments.

2. Asset-Focused Fund of Funds:

• Real Estate Fund of Funds: Diversifies across various real estate investment funds, encompassing commercial, residential, and REITs, to spread property-specific risks.

• Commodity Fund of Funds: Aggregates funds that focus on commodities, offering investment opportunities in precious metals, oil, and agricultural sectors, and serving as an inflation hedge.

3. Mixed and Specialized Fund of Funds:

• Mixed-Asset Fund of Funds: Targets broad market exposure by allocating investments across different asset classes such as stocks, bonds, and potentially alternative assets like real estate or commodities.

• Target-Date Fund of Funds: Aligns with investors' retirement horizons, progressively shifting towards more conservative investments as the target date approaches.

• Manager of Managers Fund: Employs multiple specialist investment managers to handle different portions of the investment portfolio, thus providing tailored management and a personalized investment approach.

Each of these categories addresses a distinct investment strategy and risk tolerance level, allowing investors to select a FoF that best aligns with their financial objectives and desired market participation.

Fund of Funds Fee Structure

Investors examining Fund of Funds (FoFs) will encounter a variety of fees, each reflecting a different aspect of the investment process. While terminology may differ between fund of funds, and while not all fund of funds will charge all of these fees, the substance of the fees typically falls into the following categories:

• Management Fees: This is a charge by the FoF managers for selecting and managing the portfolio of underlying funds, expressed as a percentage of assets under management.

• Underlying Fund Fees: In addition to the FoF's own management fees, each underlying fund levies its own charges, which also affect the total return of the FoF investment.

• Performance Fees: These fees are a share of the profits earned by the FoF, designed to incentivize managers to surpass benchmark performance goals.

• Operational Costs: The day-to-day running of the FoF incurs operational expenses, including administration, auditing, and legal services, which are passed on to the investor.

• Transaction Fees: Investors may be subject to charges when they buy (subscription fees) or sell (redemption fees) shares in the FoF.

• Gate Fees: To manage fund liquidity and mitigate the effects of large, sudden withdrawals, FoFs may implement costs to discourage significant redemptions, sometimes referred to as “gate fees”. In addition, the FoF may potentially restrict the size timing of redemptions altogether. 

Understanding these fees is crucial for investors to fully grasp the cost implications of investing in FoFs and how these expenses can impact investment returns.

Key Takeaways

Although they may seem unnecessary, Fund of Funds (FoFs) are an investment vehicle that provide certain kinds of investors with a valuable blend of diversification and expertise.

• FoFs can provide diversification through a single investment, enabling access to varied asset classes and the experience of specialized fund managers.

• Their attractiveness will depend on how well they balance this unique value-add against the second layer of fees that they charge investors.
  

• The presence of major entities like Blackstone, Goldman Sachs, and HarbourVest in the FoFs landscape underscores the scalability of this investment strategy and its influence in the financial markets.

In summary, Funds of Funds offer a mix of varied investments and professional management, making complex investment strategies more accessible to investors.

Additional Resources

If you found this article useful, consider checking out our Complete Finance & Valuation Course where we help students learn the technical skills needed to perform in competitive finance and investment roles. Use this course to join our students who have landed roles at Goldman Sachs, Amazon, Bloomberg, and other great companies!

Other Articles You Might Find Helpful

• Private Equity Careers
• Asset Management Overview
• Real Estate Careers 
• Highest Paying Investment Banks
• Must Know Finance Interview Questions