What Is A Fund Of Funds

Simply stated, a fund of funds (abbreviated as FoF) acts as a “meta-fund” using pooled capital to invest in a diversified portfolio of underlying investment funds being managed by third parties. The approach allows small- to medium-sized fund managers to overcome obstacles around high investment minimums, talent sourcing, portfolio concentration risk, and stringent qualification requirements when attempting to directly access top-tier alternative investment funds traditionally dominated by large institutional investors.

While a fund-of-funds model theoretically applies to registered mutual funds and ETFs, in practice, it most commonly targets higher-return alternative asset classes like hedge funds, managed futures funds, private equity, venture capital, real estate funds, and more.   

Structurally, pooled capital flows from fund of funds investors into a master fund entity, managed by the fund of funds manager, who evaluates and selects the universe of underlying fund investments. The fund of funds manager handles all aspects of portfolio construction, cash flows, liquidity management, risk mitigation, transparency reporting, and investor relations on behalf of investors, while the underlying managers focus purely on deploying capital based on their niche investment mandates.

In exchange for this turnkey, one-stop access to blue chip alternative funds, the fund of funds manager charges both a management fee (around 1.5%) and a performance fee (10-25% of profits) — above and beyond the underlying managers’ fees. Investors must determine if the amplified diversification, risk-adjusted return optimization, heightened manager redundancy, and overall convenience merit these added costs.

Typical fund-of-funds portfolios strategically allocate across underlying fund strategies and asset classes, almost like multi-asset class mutual funds. For instance, a $100M fund of funds may deploy $40M into equity funds, $30M to fixed income and credit, $20M into managed futures/CTAs trend followers, and $10M set aside as cash reserves based on the portfolio’s liquidity terms. As market conditions shift, the manager dynamically rebalances allocations between underlying strategies.

This differentiated approach allows investors to gain exposure to marquee multi-billion-dollar institutional alternative investment managers running highly focused strategies unattainable to all but the largest investors.

For example, fund of fund underlying portfolio holdings routinely include elite but capacity-constrained hedge funds such as Renaissance Technologies, D.E. Shaw, Citadel, Millennium, and Two Sigma, unavailable to even ultra-high-net-worth investors trying to invest on their own.

Contrast this fund-of-funds approach with that of traditional, standalone hedge funds. Single-manager hedge funds marshal all resources towards a specific investing strategy, typically relying more concentrated bets around narrow sectors, security types, geographies, and specialized situations versus a diversified portfolio. While agreements vary, standard hedge fund fee structures charge a 2% management fee and a 20% performance fee. 

The narrow mandate allows laser focus but heightens risk should the thesis fail. Standalone hedge funds also frequently implement higher-octane strategies involving substantial leverage, derivatives, and complexity that are less appropriate for conservative or retail investors. Minimum investments often run from $250,000 for newer entrants up to the $20M+ range for elite, pedigreed funds, closing the door to less affluent investors.

While returns vary widely based on strategy, the best-performing hedge funds historically generate net returns to investors in the high single digits to mid-teens. However, the ride can be volatile, as illustrated by broad hedge fund indices repeatedly experiencing peak-to-trough drawdowns of 20% or more during market shocks.

Contrast this to the fund-of-funds approach, where capital flows into 10-25 underlying fund managers running varied strategies. The model Essentially creates a hedge fund “mutual fund”, packaged with manager redundancy to limit blow-ups, strategy diversification, lower volatility, and access to coveted funds unapproachable for everyday investors. 

Given risk mitigation from multiple underlying strategies, the blended returns typically fall in the 6-10% range but with much less volatility. Enhanced transparency around holdings also promotes confidence for skittish investors.

Regarding expenses, the fund of funds charges higher overall fees than direct hedge fund investing because both the underlying funds and the overarching fund of funds managers take cuts of the profits. All-in costs generally approximate a 1.5% annual management fee and 15-25% performance fee in profitable years. 

Despite higher nominal fees, investors are indeed paying for increased convenience, governance, transparency, and access associated with tapping elite alternative managers. In return, they receive professional portfolio construction that optimizes risk-adjusted returns unavailable to individuals.

Overall, funds of funds occupy a unique positioning to propel emerging managers via turnkey access to institutional funds while mitigating concentration risk. Higher fees accompany the convenience, but enhanced governance, diversification, manager access, and transparency often support the added costs.

Before directly approaching top-tier hedge funds or private capital funds, curious managers should analyze if leveraging a multi-manager platform makes strategic sense early in their trajectory.

What is an example of a fund of funds?

A common example of a fund of funds is a hedge fund FoF that pools capital from multiple investors and allocates it across a diversified portfolio of underlying hedge funds, each with its own specific strategy and manager. This allows investors to gain exposure to various top-tier hedge funds that may otherwise be inaccessible due to high minimum investment requirements.

 

What is the difference between a mutual fund and a fund of funds?

A mutual fund typically invests directly in a diversified portfolio of stocks, bonds, or other securities. In contrast, a fund of funds invests in a portfolio of other investment funds, such as hedge funds or private equity funds. Fund of funds offer access to a wider range of specialized strategies and elite managers but often come with higher fees.

What is the difference between ETF and FoF?

An Exchange-Traded Fund (ETF) is a type of investment fund traded on stock exchanges, much like stocks. ETFs typically track an index, sector, or asset class and offer low costs and high liquidity. In contrast, a Fund of Funds (FoF) is a pooled investment vehicle that invests in a portfolio of other investment funds, usually focusing on alternative assets like hedge funds or private equity. FoFs generally have higher fees and lower liquidity than ETFs.