The Pros and Cons of Investing in Fund of Funds

fund of funds

The term “fund of fund” (FOF) describes an investment strategy by which funds buy and sell positions in other funds. Also known as multi-manager investments, fund of funds come in a multitude of strategies and focuses. Primarily, there are 4 main types of funds including hedge fund FOFs, private equity FOFs, mutual fund FOFs and investment trust FOFs, with their categorizations dependent upon the types of funds they trade within their strategies.

In addition to classifications based on investment approaches, fund of funds are also designated as either fettered or unfettered. FOFs whose investments are restricted to other funds managed by its own company are “fettered”, whereas FOFs that have the flexibility to invest outside their own companies’ offerings are “unfettered.” According to research by FE Trustnet, from 2006 to 2011, fettered funds performed better than unfettered funds over both 3-year and 5-year periods. This result stemmed from the fact that fettered funds typically have lower total expense ratios (the total costs of owning a fund, including investment advisory fees, administrative costs, etc.), as well as better information flow due to direct relationships and close access to in-house management teams.

Clearly, investors have a multitude of options when deciding whether fund of funds are a good fit for their portfolios. However, as is the case with any financial asset class, there are a number of pros and cons to investing in fund of funds.

Pros

  • Higher levels of diversification. Through a single investment, FOF managers are able to tap into portfolios consisting of various underlying assets.
  • Lower levels of volatility. Through increased diversification, FOFs benefit from less exposure to market volatility.
  • Access to experienced fund managers. FOF managers can conduct due diligence and opt to invest in funds managed by those with longer years of experience and stronger track records of success.
  • Additional layer of screening. Theoretically, FOFs offer an additional layer of due diligence and protection as the managers of the underlying funds have already conducted research on the initial underlying investments.

Cons

  • Higher management and incentive fees. In addition to charging their own fees, FOFs tend to pass through fees from the underlying funds as well.
  • Lower returns. In general, in exchange for more diversification, FOFs tend to offer more average returns.
  • Lack of transparency. Due to limited visibility into the underlying investments of selected funds, it may be more difficult to monitor or keep track of the overall holdings of FOFs.

 

Both benefits and concerns exist for fund of fund investments, and investors must decide whether or not this asset class is a good addition to their portfolios. If they decide that they are, platforms such as DarcMatter can help facilitate the due diligence process so that investors can conduct research and obtain sufficient information before executing on particular funds.

 

DarcMatter (“DM”) is a global fintech platform that streamlines the capital raising process for asset managers and provides investors with transparent and direct access to funds in the asset management industry.

DM’s mission is to enhance capital flow through fintech to create transparency and efficiency by providing direct access to funds in the Asset Management industry for Accredited Investors, Advisors, and Asset Managers.

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