What it means
Imagine an investor who wants exposure to many different strategies but has neither the time nor the knowledge to pick between hundreds of funds. A fund of funds hires a team to choose the underlying funds, divide the money between them and monitor their results.
The investor buys one holding and gets the whole portfolio. These funds come in several forms.
Some invest in other mutual funds and are used for target-date retirement products, which shift gradually from shares to bonds as the investor gets older. Others invest in hedge funds or private equity funds, giving smaller investors access to strategies that would otherwise need very large minimum investments.
The main benefits are diversification, professional selection and simplicity. A single fund of funds can spread money across many managers, regions and asset types, and the manager can swap out a weak underlying fund without the investor having to do anything.
For people with modest sums, this convenience can be worth a lot, since building a similar spread themselves would mean many separate purchases and minimum investments. The main drawback is the layering of costs.
The investor pays the fund of funds manager a fee, and each underlying fund also charges its own fee, so the total cost can be noticeably higher than owning one fund directly. Some products reduce the problem by using low-cost underlying funds, so it pays to look at the total expense, not just the headline fee.
A further nuance is that diversification across funds does not guarantee safety. If the underlying funds all own similar assets, a fall in that market hits every one of them, and a fund of funds investing in hard-to-sell assets can also face delays in withdrawing money.
In practice
Real-world examples.
Example
A 35-year-old saver puts $30,000 into a target-date retirement fund, which is a fund of funds. It holds several underlying share and bond funds and moves gradually toward safer assets as her retirement date approaches. She never needs to rebalance the portfolio herself.
Example
A wealthy family office with $10 million wants exposure to hedge funds but cannot pick between hundreds of managers. It invests through a hedge fund of funds that carries out due diligence, spreads the money across a dozen managers and monitors them. The family accepts the extra fee in return for the research.
Example
A small business owner investing through a workplace plan chooses a fund of funds labelled "moderate growth". The product splits her contributions between share, bond and property funds. She receives one statement instead of several, and the provider adjusts the mix each year without any action from her.
Formula
Calculation
Total annual cost rate = fund of funds fee rate + weighted average of the underlying fund fee rates
Suppose a fund of funds charges 0.50% a year and invests 60% of its money in Fund A, which charges 0.40%, and 40% in Fund B, which charges 1.00%. The weighted average underlying fee = (0.60 x 0.40%) + (0.40 x 1.00%) = 0.24% + 0.40% = 0.64%. Total annual cost rate = 0.50% + 0.64% = 1.14%. On an investment of $100,000, that is 100,000 x 0.0114 = $1,140 a year.Case study
Seen in the real world.
Lakeshore Wealth is an illustrative, fictional advisory firm that recommended a hedge fund of funds to a client with $500,000 to invest. The client liked the idea of spreading risk across eight different managers.
When the advisor reviewed the fee table, the total cost came to just over 3% a year once both layers of fees were added together. The advisor modelled the effect over ten years and found that the extra fee layer would absorb a large part of the expected return.
In this illustrative case, the client chose a lower-cost fund of funds made up of index funds instead. The story shows why the total cost across all layers is the number that matters, and the advisor now asks for a full fee table before presenting any fund of funds to a client.
Watch out
Common mistakes.
- Looking only at the top-level fee, when the underlying funds charge their own fees that are added on top.
- Assuming that holding many funds means being safe, when the funds may own very similar assets and fall together.
- Forgetting that a fund of funds can restrict withdrawals if its underlying funds are slow to pay out.
Questions
People also ask.
Is a fund of funds the same as a diversified fund?
Not exactly, since a diversified fund holds individual securities directly, while a fund of funds holds other funds.
Who benefits most from a fund of funds?
Investors who want broad diversification, professional selection and convenience, and who value that more than the extra cost.
How can I check the true cost?
Add the fund of funds expense ratio to the weighted expense ratios of the underlying funds, or look for the total expense figure in the fund's documents.
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