How Do Funds of Funds Work

Investing in stocks, bonds, cash, and other asset classes is prevalent among investors. Usually, they make these investments themselves or through investment advisors. Some investors may also pool their capital and invest it into a fund. These funds have managers that make investments on their behalf. These may include hedge funds, mutual funds, etc. Like other investments, investors can also pool their capital to invest in funds.

What are Funds of Funds?

Funds of funds (FOF) involve investors pooling their capital together to invest in other funds. These are multi-manager investments that include funds as their underlying investments. Conventional funds invest in various asset classes on investors’ behalf. Funds of funds, on the other hand, invest in those funds. In short, these funds manage a portfolio for investors that include other funds.

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Funds are a type of investment for investors. Since investors can invest in funds, it is also possible for other funds to do so. Usually, funds of funds include investments in hedge funds or mutual funds. Through this process, investors can achieve better diversification compared to investing in those funds directly. Therefore, investors can reduce the risks involved with their portfolios while also getting similar results.

How do Funds of Funds work?

The strategy that funds of funds use may differ from one fund to another. Usually, these funds work similarly to others. They identify various investments that they believe can maximize their investors’ wealth. However, these investments do not include traditional assets, i.e., stocks, bonds, cash, etc. Instead, they consist of other funds that invest in those conventional asset classes.

Funds of funds also have an asset allocation strategy. Based on this strategy, they include various funds that focus on stocks, debts, or other securities. FOFs may exist as hedge funds, private equity funds, or mutual funds. These funds may include investments in both domestic and foreign markets. Usually, FOFs employ highly competent managers to get the best output.

The primary objective for funds of funds is diversification. However, these funds also focus on identifying appropriate investments that can meet their investment goals. They allocate assets across a wide range of fund categories. Some FOFs may be fettered, while others are unfettered. Fettered FOFs invest in portfolios managed by a single investment company. In contrast, unfettered FOFs invest in funds outside their offerings.

What are the benefits and drawbacks of Funds of Funds?

Funds of funds are a great option for investors looking to invest in funds but cannot do so. Through FOFs, investors can allow qualified managers to make investments on their behalf. Similarly, they can achieve better diversification compared to investing in a single fund. Therefore, they can reduce their exposure to risk while not sacrificing a great deal on returns.

However, having a qualified manager making decisions on investors’ behalf can be costly. Usually, investors have to pay higher fees when investing in funds of funds. Some managers may also take unwanted risks to increase their performance-based fees, which is not optimal for investors. Similarly, while not significant, they lose some gains compared to if they invest in funds directly.

Conclusion

Funds of funds are pooled funds that invest in other funds. These funds, usually structured as mutual or hedge funds, employ a professional manager to make these investments. FOFs are highly favourable investments for investors that want to reduce their risks through diversification. However, they also come with some drawbacks, as stated above.

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