What is a fund of funds? (2024)

Diversification helps investors spread out their portfolio risk, but building a diversified portfolio with individual holdings can be time-consuming and difficult. One option for investors is to own a fund of funds, which are pooled investment vehicles that buy other types of funds.

Chris Berkel, founder of AXIS Financial, says funds of funds are geared to retail investors who don’t have the net worth to buy into a hedge fund or other institutional-type investment funds.

“It’s a great opportunity for your everyday investor to have pieces of the market that they otherwise may not even know were there,” Berkel says. “That doesn’t mean they don’t have their pros and cons.”

What is a fund of funds and how does it work?

Unlike traditional mutual funds or exchange-traded funds (ETFs) that buy individual securities to create a diversified investment, funds of funds, also called multi-manager funds, diversify by owning other funds run by different managers, hence the term multi-manager.

Funds of funds may own other mutual funds or ETFs, but they may also own alternative investments, such as real estate, private equity or private infrastructure projects. Strategies will differ between these vehicles, depending on the manager’s goal, Berkel says.

Funds of funds are sometimes used by investors to get very broad diversification and hedge against big losses caused by market turmoil. Depending on the manager’s skill, funds of funds may offer a higher return than traditional markets.

The different types of funds of funds

Funds of funds can have many different strategies and are generally categorized as “fettered” or “unfettered” funds.

Fettered funds of funds can only select from other funds managed by the company that issues the investment vehicle. Unfettered funds of funds can select funds beyond the investment company’s offerings.

The advantages of a fund of funds

Diversification is the big selling point for a fund of funds since investors can own a broad array of different funds in a single holding. These vehicles also open access to slices of alternative investments retail investors normally can’t afford to buy individually.

They’re also accessible to the average person who wants access to a professional manager, says Daniel Milan, managing partner at Cornerstone Financial Services. Directly investing in private equity or hedge funds may cost individual investors millions, “but a fund of funds may be $2,500,” he says.

The disadvantages of a fund of funds

Diversification in a fund of funds comes at a steep cost, Milan says.

“They’re more expensive from an expense-ratio standpoint than the average retail investors are typically used to. Now, in theory, you’re supposed to be getting a better return in exchange for that,” he says.

Costs are a big issue because each fund contained in a fund of funds has a separate fee to pay those managers, and there’s a fee to own the fund itself. Billy Voyles, president of Fundamental Wealth Designs, uses a sports analogy to explain the layers.

“It’s like hiring a coach to oversee the game plan, but inside each fund you have coaches overseeing their specific areas,” he says.

Berkel says the total cost between the individual fund manager fees and the fee for the fund itself can average around 2%.

Hedge funds versus funds of funds

Hedge funds and funds of funds both own other funds within the investment vehicle, but there are key differences. A hedge fund is limited to accredited investors, Voyles says.

The Securities and Exchange Commission (SEC) defines accredited investors as individuals who have a net worth of over $1 million, excluding their primary residence, owned jointly with a spouse or partner, or individually. Accredited investors also have had individual income of over $200,000 ($300,000 with a spouse or partner) for the previous two years and expect that high income level to continue in the current year. The SEC limits access to hedge funds to accredited investors because hedge funds have more leeway to buy riskier investments.

Hedge funds can own individual traditional investments, such as stocks, bonds and options, or alternative investments, such as private equity or private debt. Managers of hedge funds of funds also buy other funds to include in their portfolios.

Voyles says retail-focused funds of funds are open to any investor who seeks a hedge-fund-like investment style. “You get access to professional management through funds of funds as a regular investor. You don’t have to be accredited to get access to that,” he says.

How to invest in a fund of funds

To find a fund of funds, search for the terms “fund of funds” or “multi-manager” within your preferred mutual fund or ETF issuer. Many fund issuers offer these funds, including Vanguard, Fidelity, Neuberger Berman and others. Generally, these funds will be taxed based on the structure of the fund if they are held in a taxable brokerage account. ETF investors usually pay little in annual capital gains taxes given that they don’t distribute much in capital gains, while mutual-fund investors often pay capital gains taxes on distributions annually. However, if the funds own alternative investments, buyers of these funds may face ordinary income tax. It’s important to read the prospectus to understand the potential tax implications.

Milan thinks an alternative to owning high-fee funds of funds is to own the public stock of private investment managers, such as Blackstone and Apollo Management.

“Their stocks are publicly traded. Yes, stocks are going to be significantly more volatile. But that’s your exposure to private equity, and you’re doing it at no cost because you’re buying individual stocks,” he says.

Before investors buy a fund of funds, Milan says they should carefully read the fund’s prospectus to get a true understanding of the layers of fees. “The prospectus is going to have what the fund operating expenses are. You need that. You’ve gotta go in eyes wide open,” he says.