Fund of Funds (FOF)

Funds of Funds (FOF) mean pooled funds on investors which are not directly invested in stocks/securities i.e., it is a portfolio which contains a portfolio of other funds also known as a multi-manager investment and they invest in hedge funds, mutual funds, stocks, bonds and various other types of securities. It is popularly called a Collective Investment or a Multi-Manager investment fund.

Investing in the fund of funds allows investors to have diversified portfolio as these FOF alternatives help them invest in different types of funds simultaneously. The asset allocation is smartly done per their understanding to balance the risks and rewards obtained in return of the investments.

• A fund of funds is a portfolio that comprises multiple underlying funds and invests in a range of securities, such as hedge funds, mutual funds, stocks, bonds, and other types of securities.
• Funds of funds are pooled investment vehicles where investors indirectly invest in stocks or other securities. They are commonly referred to as Multi-Manager Investment Funds or Collective Investments.
• The primary objective of this strategy is to diversify investments across various fund categories, combining them into a single fund in order to achieve appropriate asset allocation and broad diversification.

Fund of Funds (FOF) is a pain-free entrance to a saturating hedge fund industry, not promising exorbitant returns before the 2008 Financial crisis. It is relatively less tedious for investors to enter with a limited amount of funds or those who are relatively inexperienced with the handling of hedge funds. It should not be taken for granted that despite taking all such precautions, FOF would be a perfect fit for the appetite of the investor. An investor should carefully go through the fund’s offer documents and associated materials before making the investments so that the level of risk involved in the fund’s investment strategies is clearly understood. The risks undertaken should be in the same wavelength as the investors’ personal investment goals, risk tolerance, and time horizons.

This strategy aims to achieve appropriate asset allocation and broad diversification with investments in various fund categories, which all culminate in a single fund. Such funds are attractive to small investors open to broader exposure categories with fewer risks than a direct investment in securities. This gives them a comfort level of their principal investment not getting wiped out due to market volatility or events like counterparty default, extended inflation, recessionary pressures, etc.

FOF follows this by constructing a portfolio of other hedge funds, which could differ depending on the investment strategies respective funds have applied. A portfolio manager uses his or her skill and experience to select the best underlying hedge fund based on past performance and other relevant factors. If the manager is talented, this can increase return potential and decrease risk potential.

FOF management companies either invest directly into the hedge funds by buying shares or offer investors access to managed accounts that mirror the performance of the hedge fund. Segregated or Managed accounts have grown in popularity since they provide investors with a Daily Risk reporting and helping to protect the assets of investors if the hedge fund goes into Liquidation.

With such funds, there is an additional benefit given that most of the other hedge funds have prohibitively high minimum initial investments. Through such a fund structure, investors can theoretically gain access to some country’s best hedge funds with a relatively smaller amount of investment. E.g., if an investor desires to invest in 5 hedge funds to diversify its risk portfolio, then the minimum investment would be $50 million (assuming a minimum $10 million investment per fund). However, if there is a Fund of a hedge fund that invests in the underlying of all five such funds, then the investor can have access to the benefits of all the funds with an investment of $10 million. If the fund is managed efficiently, it could even charge a smaller amount of investment.

This amount can be adjusted depending on the variety and number of the funds in which the investments will be made. The skills of the fund manager are critical in deciding the number of funds in which diversification has to be made. It is a very dynamic activity since constant monitoring is essential for all funds and industries.

Let us consider the following instances to understand the fund of funds definition better while learning about its proper working as well at the same time:

Example 1

Imagine Jenny wants to invest in a financial instrument without taking much risk. She comes to know from one of her friends about FOF options. As she explores the alternative, she comes to know how investing in different funds at the same time would keep her financially balanced. Hence, she decides to invest in fund of funds, whereby she allocates asset and diversifies her investments.

She invests in one mutual funds plan, one gold fund plan, and one debt fund scheme – all in one through FOF. This way, she ensures that even if the returns are not much for one, leading to loss, she would still be capable of covering up for the same using the positive returns reaped on the other investments.

Example 2

Indian wealth management firm Waterfield Advisors, according to a report published in November 2023, is all set to expand its services globally. To achieve its goal, however, it is aiming to raise its fund of funds worth $250 million. The firm revealed its plans of closing the first set of these funds in the next two-and-a-half months. Waterfield Advisory serves advisor to over 100 family offices in the nation and it aims to begin dominating Dubai very soon.

There are inherent risks applicable to hedge funds, and if the FOG has invested in a particular hedge fund, then threats get automatically carried on to it.

• Lack of Liquidity: Hedge funds, whether registered or unregistered, are investments challenging to be converted into cash in addition to possible restrictions on its transfer or re-selling ability. There are no fixed rules on the pricing of its securities, especially the illiquid ones. When the price of a security is not available, its value may be calculated based on either price available by Bloomberg data or at cost. Registered units of the hedge funds may not be redeemable at investor’s discretion, and perhaps there is no secondary market for the sale of such hedge fund units. In simple words, one may not be able to exit the investment at the desire of the investor.
• Adverse Tax Consequences: The taxation structure of registered FOR may be complicated. There can be a possible delay in receipt of important information about tax payment, which will delay the filing of the income tax return process.
• Over- Diversification: A FOF needs to coordinate its holdings. It will not add value. If not vigilant, it may unintentionally collect a group of hedge funds that duplicate its various positions or represent sub-standard quality concerning the rest of the market. Multiple individual hedge fund holdings with the aim of successful diversification are likely to reduce the benefits of dynamic management, despite executing the double-fee structure in the meantime. Several studies have been conducted regarding the number of hedge funds for diversification, but the “sweet spot” seems to be around 8 to 15 hedge funds.

There are some critical benefits in addition to the above points offered by such a structure:

• Hedge funds can tend to be very opaque regarding their asset classes and their strategies. A FOF serves as an Investor’s Proxy responsible for performing due diligence, Manager Selection, and oversight of the hedge fund within its portfolio.
• The due diligence of the FOF Manager is a formal process that involves conducting background checks before the selection of new managers. An in-depth investigation is executed for searching the disciplinary history of the manager with the securities industry, researching their backgrounds, verifying their credentials, and checking references of the individual who desires to be Manager of FOF.
• Such funds may allow investors into funds that are already closed to new investors if the fund of the fund already has cash placed with a particular manager.
• One can also have institutional advantages as one can make investments in various funds, which are, in other ways, off-limits for the retail investors.
• With careful use of leverage and short selling, hedge fund returns can amplify against a declining market. Short positions can lose an unlimited amount of money, while power can magnify the losses making a quick entry and exit more difficult. However, if these techniques are used wisely, then such tactics can give rich returns.

A significant drawback of investing in such a fund is the number of Fees charged. In addition to the Management Fees (around 1.5%-2% of the Assets under Management) and Incentive Fees (15%-25% of the Assets), such funds charge an “Incremental Fee.” It is widely argued that the structure of such incremental fees is relatively more massive than the Potential higher Risk-adjusted returns offered by the FOF. E.g., the manager is entitled to receive 10% of any annual gain exceeding 8% risk-adjusted return or the Alpha. Since it will invest in several private funds, the FOG also bears part of the fees and expenses of those underlying hedge funds as well.

• Since hedge funds are not necessarily required to be registered with the Securities & Exchange Commission (SEC),  the investors can become defensive in their approach. Hedge funds are typically sold in Private offerings, which means they are not publicly reported like Mutual funds. Such comparison may reduce the benefits of a FOF over Mutual Funds.
• The aspect of Diversification can be a double-edged sword whereby a mixture of various kinds of hedge funds may reduce an investor’s exposure; however, investors will be subject to higher fees but volatile returns. Hence too much diversification may not necessarily be a beneficial option.

FOF and mutual funds are quite commonly used in the financial markets. In fact, the two are often confused and mistakenly used as a substitute. However, using them synonymously is incorrect. To understand this, it is important to explore the differences between the two. Let us have a look at a few of them:

• A mutual fund is an investment vehicle that pools finances from different investors to purchase assets and securities. On the contrary, FOF is an instrument that pools multiple funds together as one. Here, the investment can be made in mutual funds, debt funds, etc.
• FOFs are best for novice investors as it keeps the investment profile balanced, while mutual fund investments are for those who are experienced.
• Investors with limited assets can opt for FOF. On the other hand, mutual funds are for all, especially those who have enough assets to allocate.

This has been a guide to what is Fund of Funds (FOF). We explain it along with examples, vs mutual funds, advantages & disadvantages, and investment risks. You may learn more about Portfolio Management from the following articles –

• Types of Mutual Funds
• Index Funds and Mutual Funds
• What are Mutual Funds?
• Mutual Funds and ETFs