Fund of Funds (FOF)

A Fund of Funds (FOF) is a type of investment instrument that pools capital from many investors and invests it in a portfolio of other funds. It opposed straight investments in assets.

Diversification and asset allocation are the goals to expose investors to various investments. It is also lowering risk at the same time. 

An investing expert chooses and manages the underlying funds in the portfolio that make up the FOF. However, the idea of Fund of Funds was developed in the early 20th century. It became well-known in the US in the 1960s.

The Central Trust Company of Cincinnati invested in a diverse range of mutual funds and launched the first FoF in 1949. The number of FoFs increased during the 1970s. As a result, investors sought out strategies to diversify their portfolios and lower risk.

Due to rising demand from institutional investors like pension funds, endowments, and foundations, the industry saw tremendous expansion in the 1980s and 1990s. 

The advent of new investment vehicles like hedge funds, private equity, and real estate funds further fueled the rise of this industry.

This industry had difficulties in the early 2000s. It was all due to heightened scrutiny of fees and performance and the 2008 global financial crisis. 

Yet, the market has recovered and is now worth over $1 trillion globally.

Both institutional and individual investors utilize them. They are offered in various structures, such as open-ended, closed-ended, and exchange-traded funds.

Types of Fund of Funds

Instead of investing directly in individual securities, Fund of Funds are investment entities that combine investor money and invest in a diverse portfolio of other funds.

It is available as open-ended, closed-ended, and exchange-traded funds, among other variations. Each kind has its own qualities, benefits, and drawbacks.

1. Open-Ended Fund of Funds 

Open-ended FoFs allow investors to buy and sell shares at any time based on the fund's net asset value (NAV). The entire value of the fund's assets is divided by the number of outstanding shares to determine the NAV at the conclusion of each trading day. 

According to their investment strategy and objectives, the fund manager must distribute the fund's assets among the underlying funds. In terms of investment size and redemption criteria, open-ended FoFs often offer more flexibility than other types of FoFs.

⇒ Advantages

• Investors always have access to shares thanks to liquidity.
• A seasoned portfolio manager oversees the operation of the fund.
• Open-ended FoFs provide diversity across many underlying funds.

⇒ Disadvantages

• Compared to other types of FoFs, it has higher fees.
• Due to a more complicated structure, it may not offer as much transparency as other types.
• To stop significant redemptions from upsetting the fund's underlying investments, the fund manager may apply redeemable limits.

2. Closed-Ended Fund of Funds

Closed-ended Investors must buy shares from other investors since they have a set quantity of shares traded on stock markets. 

The fund's NAV is not determined daily, in contrast to open-ended, and the shares may trade at a premium or discount to the NAV.

⇒ Advantages

• A seasoned portfolio manager oversees the operation of the fund.
• It provides diversification by allowing investors to choose from various underlying funds.
• Investors can purchase shares below the NAV, which could result in larger returns.

⇒ Disadvantages

• Its shares may not be as liquid as an open-ended FoF's shares.
• Its shares may trade above NAV, which would lower prospective returns.
• In general, it has greater fees than other kinds of FoFs. 

3. Exchange-Traded Fund of Funds

Exchange-traded FoFs can be purchased and sold all day long on stock exchanges and are traded like equities. They give investors the benefits of both exchange-traded funds and FOFs. It offers greater transparency and liquidity than other types while charging fewer costs.

⇒ Advantages

• Compared to other types, it often has lower fees.
• During market hours, investors may buy and sell shares anytime.
• It provides diversification across many underlying funds.
• Compared to other types, it offers more transparency.

⇒ Disadvantages

• While purchasing or selling shares, investors may incur trading expenses.
• The underlying funds may not be directly under the control of investors.
• It may not track the performance of the underlying funds. Therefore, it is a potential tracking issue.

An investor's choice of FoF is influenced by their investing goals, level of risk tolerance, and liquidity needs.

Advantages and disadvantages of Fund Of Funds

FoF is a particular class of investment instruments that add investor funds and invest them in a selection of other investment funds.

Professionals who choose and invest in different underlying funds, such as hedge, mutual, or private equity funds, manage them. 

While it can assist investors in some ways, there may also be some negative aspects to consider.

⇒ The advantages of FoF are given below:

1. Diversification

Assists investors by investing in various underlying funds. It is across various asset classes and investment strategies. By doing so, the portfolio's total risk can be decreased, and returns can be increased.

2. Professional management

Experienced managers are responsible for selecting and investing in the best-performing underlying funds. As a result, investors may have access to investment opportunities. They might not have been able to find or access it on their own.

3. Access to different asset classes

FoF exposes investors to diverse asset classes, including non-traditional investments like private equity and hedge funds. These may not be available to individual investors.

4. Lower least investment

It has lower least investment requirements. It gives investors access to a diversified portfolio of funds.

5. Lower administrative burden

Investors only need to handle one investment rather than many distinct funds.  It can ease their administrative load.

⇒ The disadvantages of FoF are given below:

1. Higher fees

Costs are sometimes greater than for individual funds, which can reduce returns. Management fees, performance fees, and administrative fees are included in the costs.

2. Limited control

Since investors rely on the fund manager to make investment decisions on their behalf, investing in FoF implies sacrificing some control over investment choices.

3. Limited transparency

Have less transparency as compared to individual investments. It makes it harder for investors to comprehend the underlying investments and their performance.

4. Overlapping holdings

Have underlying funds that have investments that overlap. It could result in overconcentration and lessen the advantages of diversification.

5. Performance risk

FoF can be unpredictable and may not always meet expectations. However, it can have an impact on its performance. It offers investors advantages like diversification, accessibility to various asset classes, and expert management. 

Investors must also consider any potential negatives of it, such as greater fees, fewer control options, and decreased transparency.

Comparison of Fund of Funds with other investment options

To invest in various underlying funds, the Fund of Funds investment option pools investor funds. It offers diversity, access to various asset classes, and expert management.

These investment options differ from others in the following ways:

1. Mutual funds

Both mutual funds and FoFs pool investor capital to invest in a range of assets. FoF invests in other mutual funds instead of stocks, bonds, or other types of securities.

2. Exchange-Traded Funds (ETFs)

Unlike FoFs, ETFs are traded on stock exchanges. ETFs and FoFs both provide diversity and professional management. ETFs make investments in a certain asset class. In numerous ETFs and other funds, it might invest.

3. Hedge funds

FoFs don't often accept accredited investors, although hedge funds do. It provides more flexible investment strategies. They may invest in real estate, private equity, or other alternative assets. Compared to FoFs, hedge funds have more restrictions and higher costs.

4. Individual securities

Buying individual bonds or equities gives investors more influence over their overall investment strategy. Yet doing so also calls for additional market analysis.

5. Real estate investment trusts (REITs)

Like FoFs, REITs use investor money to buy real estate. More variety is provided. Instead of REITs, they can invest in a range of REITs and other funds. It makes investments in just one kind of property.

6. Robo-advisors

Using algorithms, robo-advisors create and manage financial portfolios. They offer automated rebalancing and low expenses. Nonetheless, they might lack the adaptability and focus of a human counsel. FoFs offer more expert management and diversification than other robo-advisors.

FoF offers diversity, skilled management, and access to various asset types. However, when compared to other investment opportunities, such as robo-advisors, mutual funds, ETFs, hedge funds, individual stocks, and REITs, it has specific benefits and drawbacks. 

Investors should consider their investment goals, risk tolerance, and costs while investing.

Future outlook for the Fund of Funds industry

Instead of making direct investments in assets, the Fund of Funds business combines investor money to invest in various investment funds. This sector has experienced rapid growth in recent years, but what does the future hold for this industry?

 These are some possible perspectives:

1. Growing demand

As investors look to diversify their portfolios and lower risk, this market is anticipated to continue growing. In addition, it provides a practical and affordable option to access these markets as more investors seek alternative assets like private equity and hedge funds.

2. Industry consolidation

There are many minor firms in the highly fragmented market. Yet, as the market matures, consolidation may occur as bigger competitors look to get economies of scale and boost their market position.

3. Rise of ESG FoFs

ESG FoFs are rising as investors emphasize environmental, social, and governance (ESG) factors more. Therefore, the number of ESG FoFs that invest in funds with a strong ESG focus may increase.

4. Increased competition from ETFs

Exchange-traded funds (ETFs) are becoming increasingly popular among investors due to their low costs and simplicity of use. As a result, ETFs might provide a greater threat to FoFs in the future.

5. Technology-driven innovation

The asset management sector, including this sector, is seeing rapid change due to technology. As a result, new technology-driven FoFs may emerge. These technologies manage portfolios and choose investments based on algorithms and artificial intelligence.

6. Regulatory scrutiny

This sector is anticipated to experience more regulatory scrutiny in the future. It will be with regard to matters like transparency, costs, and conflicts of interest. As a result, it could need to adjust to new rules and provide investors with more information.

7. Focus on performance

It will continue to be under pressure to provide investors with solid returns. As a result, more emphasis might be placed on performance and employing complex investment techniques to produce alpha.

8. Greater use of passive investing

Since passive investing has gained popularity recently, it may use passive investment strategies to cut costs and expose investors to a wider range of markets.

In summary, the future of this business is expected to bring both opportunities and difficulties. The industry is anticipated to expand more. But to keep up with shifting investor demands, heightened competition, and higher regulatory scrutiny, it will also need to adapt.

Researched & Authored by Rakesh Choudhary | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

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