A fund of funds (FOF)—also known as a multi-manager investment—is a pooled investment fund that invests in other types of funds. In other words, its portfolio contains different underlying portfolios of other funds. These holdings replace any investing directly in bonds, stocks, and other types of securities.
FOFs usually invest in other mutual funds or hedge funds. They are typically classified as “fettered,” or only able to invest in funds managed by the FOF’s managing company, or “unfettered,” or able to invest in funds across the market.
KEY TAKEAWAYS
- A fund of funds (FOF) is a pooled fund that invests in other funds.
- FOFs usually invests in other hedge funds or mutual funds.
- The fund of funds strategy aims to achieve broad diversification and minimal risk.
- Funds of funds tend to have higher expense ratios than regular mutual funds.
How a Fund of Funds (FOF) Works
The fund of funds (FOF) strategy aims to achieve broad diversification and appropriate asset allocation with investments in a variety of fund categories that are all wrapped into one portfolio.
There are different kinds of FOFs, with each type acting on a different investment scheme. A FOF may be structured as a mutual fund, a hedge fund, a private equity fund, or an investment trust. The FOF may be fettered, meaning it only invests in portfolios managed by one investment company. Alternatively, the FOF can be unfettered, letting it invests in external funds controlled by other managers from other companies.
Fund of Funds Advantages
Typically, FOFs attract small investors who want to get better exposure with fewer risks compared to directly investing in securities—or even in individual funds. Investing in a FOF gives the investor professional wealth management services and expertise.
Investing in a FOF also allows investors with limited capital to tap into diversified portfolios with different underlying assets. Many of these would be out-of-reach for the average retail investor. For example, hedge funds typically require six-figure minimum investments or require investors to have a minimum net worth—or both.
Most FOFs require a formal due-diligence procedure for their fund managers—both their own and those managing the underlying funds. Applying managers’ backgrounds are checked, which ensures the portfolio handler’s background and credentials in the securities industry.
Fund of Funds Disadvantages
Though FOFs provide diversification and less exposure to market volatility, these returns may be lessened by investment fees that are typically higher than traditional investment funds. Higher fees come from the compounding of fees on top of fees.
Like most mutual funds, a FOF carries an annual operating expense—known as the expense ratio—as well as management fees and operating costs. However, FOFs investors are essentially paying double—because the underlying funds in the FOF all have their annual costs and fees, too.
In the past, funds of funds’ prospectuses didn’t always include the fees of the underlying funds. As of January 2007, the SEC began requiring that these fees be disclosed in a line called Acquired Fund Fees and Expenses (AFFE).
A fund of funds might charge annual management fees of 0.5% to 1% to invest in funds that charge another 1% annual management fee. So, the FOF investor in sum is paying up to 2%. Small wonder that, after allocating the money invested to fees and other payable taxes, the returns of fund of funds investments may generally be lower compared to the profits that single-manager funds can provide—even if the funds perform very well.
Picking good fund managers and funds can be difficult, too—especially if the FOF is fettered. The FOF may end up owning the same stock or other security through several different funds, thus reducing the actual diversification.
Pros
- Ultimate in diversification
- Professional management expertise
- Alleviation of risk and volatility
- Exposure to assets usually beyond small investors
Cons
- Additional layer of fees
- Risk of overlap in holdings
- Difficulty in finding qualified managers, funds
Acquired Fund Fees and Expenses (AFFE),
What Are Acquired Fund Fees and Expenses (AFFE)?
Acquired fund fees and expenses (AFFE) are a line item in a multi-manager or fund-of-funds (FOF) prospectus that shows the operating expenses of the underlying funds. This became a requirement as of January 2007. This line item is now included with the fund’s fee schedule under the “fees and expenses” heading and in its prospectus.
KEY TAKEAWAYS
- Acquired fund fees and expenses (AFFE) let investors of a fund of funds (FOF) understand how much they are paying in management fees to the portfolio funds that the FOF invests in.
- AFFE appears as a mandatory line item on the fund’s fee schedule and acknowledges the more complex and layered fee structure that comes with multi-manager investment.
- Typical AFFE can range up to 10% depending on the types of funds and their associated fees that the FOF holds.
Understanding Acquired Fund Fees and Expenses
Acquired fund fees and expenses are associated with multi-manager and fund-of-funds options that have more complex fee structures. These fees increase the total annual expenses of a fund and include management fees paid to multiple managers.
A fund of funds (FOF) is a pooled investment fund such as a mutual fund or hedge fund that does not pick its own investments. Instead, these FOFs invest in other mutual funds or hedge funds. In other words, its portfolio contains different underlying portfolios of other funds managed by their own portfolio managers. These holdings replace any direct investments in assets like bonds, stocks, and other types of securities. The fund of funds (FOF) strategy aims to achieve broad diversification and appropriate asset allocation with investments in a variety of fund categories that are all wrapped into one portfolio.
An investor who purchases an FOF must pay two levels of fees. Just like an individual fund, an FOF may charge management fees and a performance fee, although the performance fees are typically lower than individual mutual funds to reflect the fact that most of the management is delegated to the sub-funds themselves.
SEC Regulation and Disclosure
In January 2007 the Securities and Exchange Commission (SEC) began instituting new provisions to the Investment Company Act of 1940, which made it easier for fund companies to register fund-of-funds options. The SEC broadened legislation under Section 12(d)(1) of the 1940 Act for multi-manager funds. The SEC also revised its registration statement forms to include additional detail on the expenses for these funds. Specifically, registration statements now require that fund managers include “acquired fund fees and expenses” as an added fee disclosure requirement for multi-managers, which must be included in the comprehensive fee schedule found in the prospectus.
Prior to 2007, fund-of-funds investing was only allowed under specific circumstances approved by the SEC. In most instances, these fund-of-funds investments would report expense ratios of zero. Disclosure was misleading, presenting that there were no expenses and reporting that there would be operating expenses incurred by the various underlying funds in the portfolio.
The new AFFE requirements now provide for more transparent disclosure of the combined relationships and expenses incurred by shareholders. The AFFE line item is added to a fund’s fee schedule and is in addition to other standard expenses of a fund. AFFE is established as a comprehensive fee made up of the individual fees the investment advisor agrees to pay to the multi-managers. AFFE can range from 0.02% to 10% depending on the agreements with individual managers.
Example: Neuberger Berman Absolute Return Multi-Manager Fund
The Neuberger Berman Absolute Return Multi-Manager Fund provides one example of the fee structuring found in multi-manager funds. The Fund is an open-end mutual fund offering Class A, Class C, and institutional shares.
Standard fees apply to the fund with management fees ranging from 1.92% to 1.81% across share classes. Distribution fees are charged for the Class A and Class C shares at 0.25% and 1.00%, respectively, with no distribution fee for institutional shares. Total other operating expenses range from 1.04% to 1.02%. Acquired fund fees and expenses round out the last fee expense line item for the Fund, with all share classes paying a 0.05% fee. Total annual expenses with waivers range from 3.94% to 2.83%.
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Real-World Example for Fund of Funds
Since they are so varied, funds of funds can be hard to track as a group and to compare. However, an index does exist. The Barclay Fund of Funds Index, sponsored by Barclay-Hedge, a provider of data on alternative investments, is a measure of the average return of all FOFs that report into the company database. Through Q1 2022, for instance, 156 funds of funds had yielded an average return of 0.33% year-to-date.2 The S&P 500 during the same period lost more than 7.5%.
Are Funds of Funds Common?
Dedicated funds of funds may be less common that standalone mutual funds or ETFs. However, the SEC estimates that approximately 40% of all registered funds hold an investment in at least one other fund.
How Much Assets Are Invested in Funds of Funds?
According to the SEC, Total net assets in mutual funds that invest primarily in other mutual funds reached over $2.54 trillion in 2019.
Are Funds of Funds Regulated by the SEC?
Yes, like all other pooled investment products, FOF are also overseen by the SEC. In particular, SEC Rule 12d1-4, updated in 2020, sets out procedures that provide a consistent framework for fund of funds arrangements.3 The SEC also requires FOFs to disclose their fees in a transparent manner.
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