An investor’s guide to FOFs: What’s a fund of funds?
A fund of funds (FOF) sounds more complex than it is. Learn more here about what an FOF is, what types there are, and key questions to ask yourself before investing.
6 min read
Depending on how far you get into investing, it can turn into a huge time commitment. If you’ve ever wondered how to diversify your investment portfolio without managing all the details yourself, you're not alone. One popular solution is a fund of funds (FOF), which might sound complex but can make investing more straightforward and diversified. In this article, we’ll cover the basics of what a fund of funds is. Plus, we’ll explore why people might choose an FOF when they’re looking to invest in multiple funds. Let’s take a closer look.
What is a fund of funds?
A fund of funds (FOF) is a pool of investors’ money that then gets invested in other funds, rather than in individual stocks or bonds. Essentially, it’s a fund made up of different funds. This means that when you invest in an FOF, you’re indirectly investing in a range of underlying funds, which in turn invest in various assets. This layered structure allows investors to quickly gain exposure to different asset classes or investment strategies without having to handpick individual funds themselves. In contrast, traditional investment funds, such as mutual funds or exchange-traded funds (ETFs), invest directly in assets like stocks, bonds, or commodities. An FOF is a portfolio of other funds, so it provides an added layer of diversification and spreads risk across even more markets, industries, or regions. This makes FOFs a popular choice for investors who want to further diversify their portfolios — although they also often come with higher fees than traditional funds.
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There are several types of FOFs, each tailored to different investment goals and asset classes. Let’s look at some of the most common ones and what makes them unique.
Fund of hedge funds
As the name suggests, a fund of hedge funds invests in multiple hedge funds. This provides investors with access to the often exclusive and high-risk hedge fund market. Hedge funds use advanced investment strategies — such as leverage, short selling, and derivatives — to maximize their returns. Sometimes, they even manage to yield returns no matter what the stock market conditions are. A fund of hedge funds helps investors access this high-potential area while spreading risk across several hedge funds. However, these types of FOFs can come with particularly high fees based on performance and management, which can cut into investors’ returns.
Fund of mutual funds
A fund of mutual funds is designed to offer investors exposure to various mutual funds, which each hold traditional assets like stocks, bonds, or a mix of both. This type of FOF is more accessible to casual investors. It offers diversification across multiple mutual funds, each with different investment strategies and risk profiles. The advantages of a fund of mutual funds are its simplicity and broad diversification.
Fund of private equity funds
A fund of private equity funds is made up of private equity funds, which focus on investing in private companies or taking public companies private. These investments are typically long-term and can offer significant returns, but they're less liquid and come with higher risk than other types of FOFs. Investing in one of these FOFs gives investors access to a diversified portfolio of private equity investments. That can limit some of the risks that come along with this asset class. However, like hedge funds, private equity funds tend to have high management fees, and many investors keep their money invested for several years.
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4 questions to ask before you invest in a fund of funds
Investing in a fund of funds can be a great way to diversify your portfolio — the diversification is a natural part of an FOF. But like any investment, it’s essential to approach it with a clear plan. Here are some key questions to ask yourself before diving in:
What’s the FOF's performance history? Past performance never guarantees future results, but it can give you an idea of how the fund’s managers have reacted to different market conditions.
How diversified is the FOF? Will your money be spread across funds with different asset classes, industries, or regions? A well-diversified FOF can help minimize risk while maximizing potential returns.
Does the manager have a good track record? The success of any FOF largely depends on the fund manager's expertise. The manager’s track record, experience, and investment strategy should align with your expectations.
How easy is it to sell? Some FOFs may have restrictions on when and how you can withdraw your money. Make sure you’re comfortable with the fund’s liquidity terms and are confident in your exit strategy.
Answering these questions in detail can help you make a more informed decision and decide whether an FOF is a good fit for your portfolio.
Future trends in FOFs
The investment landscape is constantly evolving. As markets and investor preferences change, several emerging trends are shaping the future of FOFs. Keep reading to check out some of these FOF trends and what the future might hold.
ESG investments
Environmental, Social, and Governance (ESG) investing is gaining traction across the financial world. More investors want to make socially responsible and sustainable investments, and FOFs are responding by incorporating ESG-focused funds into their portfolios. This trend seems likely to continue as global awareness of sustainability issues grows.
Alternative asset classes
Increasingly, FOFs are expanding beyond traditional investments like stocks and bonds to include alternative asset classes such as real estate, infrastructure, and cryptocurrency. This allows investors to gain exposure to non-traditional markets that may offer higher returns or act as a hedge against volatility in the stock market.
Technology and automation
The rise of fintech and automation makes investing in FOFs easier and more efficient. Digital platforms let investors access various FOF options with lower minimum investments and more transparent fee structures. Tech advancements are also enabling fund managers to analyze market trends, manage portfolios more effectively, and even automate investing.The future of FOFs looks promising as investors increasingly seek out diversified, professionally managed portfolios to help them navigate uncertain markets.
Should you invest in an FOF?
An FOF can be a good fit for investors who want even more diversification, professional management, and exposure to various asset classes. For some, it can be a convenient, one-stop shop for investing in a range of funds — and therefore, assets — without doing all the legwork yourself.However, before diving in, remember to do your homework and make sure the FOF makes sense for you and your portfolio. Carefully consider your risk tolerance, your long-term goals, and any fees that might cut into your potential returns. Understanding the basics of FOFs and investing, and staying informed about market trends, can help you make the moves that are right for you.
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FAQs
The tax implications of investing in an FOF can be complex, because taxes may apply at two levels: the FOF itself and the underlying funds it invests in. Depending on your tax base, investors might have to pay capital gains taxes if the FOF sells its shares of the underlying funds. The timing of distributions can also affect your tax liabilities.
There are pros and cons either way. FOFs can perform well because they have broad market exposure and are professionally managed — but there are added fees for managing the FOF and the underlying funds. Investors may not see the same level of growth with FOFs as you would with lower-cost direct investments. Then again, you could benefit from reduced risk because of the added diversification of an FOF.
Investors should look for FOF managers with experience, a solid track record, and a clear investment strategy. The manager’s expertise is a huge part of the FOF’s success — they’re responsible for selecting high-performing underlying funds and managing risk. It can also be wise to choose managers who are transparent about their fees and performance metrics, and whose approach fits with your goals and risk tolerance.
Yes, many FOFs have minimum investment requirements, though they can vary depending on the type of FOF and the financial institution managing it. Some FOFs, particularly in asset classes like hedge funds or private equity, may require higher minimum investments. Others, such as mutual fund FOFs, may have lower, more accessible entry points.
FOFs are designed to help diversify your portfolio by investing in various funds across asset classes, sectors, and regions. This broad diversification helps reduce risk because it spreads investments across multiple funds rather than concentrating on a few assets. As a result, FOFs can be an effective way to minimize how much impact market volatility has on a portfolio.
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