how funds of funds work
the core idea behind a fund of funds strategy is that by combining various hedge fund strategies into a single portfolio investors can achieve higher returns with less risk compared with investing in individual funds themselves this diversification aims to smooth out the volatility inherent in fund investing offering a more stable path to potential gains funds of funds are found for all kinds of strategies and include hedge exchange traded mutual private equity and other funds fofs work by pooling capital from investors and allocating it in underlying funds for the most part fof managers select these funds based on their performance management quality and investment strategy this involves due diligence including analyzing past returns measures of risk and fund managers expertise 2while traditional fofs focus on actively managed hedge funds newer fofs invest in more passive indexes and exchange traded funds etfs these more passive fofs aim to provide investors with exposure to a broad range of asset classes and investment strategies at a lower cost compared with actively managed fofs there s still active management at the fof level though since there s the need to find those indexes or etfs that align with the fof s investment objectives and risk profile the fees for a fof strategy typically involve two layers the fees charged by the underlying funds and the fees imposed by the fof manager for example if an investor places 10 000 in a fof with a 1 management fee and the underlying funds collectively charge 2 the total annual fees might be 298 100 for the fof and 198 for the underlying funds after paying the first fee this is simplified but there s no doubt these fees add up especially when including performance fees hurdle rates and other expenses that could further impact the total cost for the investor 3types of funds of fundsfofs offer investors access to a diversified portfolio of funds through a single investment by pooling capital and spreading it across various underlying funds fofs provide professional management diversification and access to strategies or managers that may otherwise be difficult for individual investors to obtain fofs come in various types each designed for different investor needs risk preferences and investment objectives these types can be broadly categorized based on the underlying assets they invest in such as hedge funds mutual funds private equity real estate or commodities in addition some fofs employ specific trading strategies or invest in particular sectors or geographic regions 4the table below provides an overview of the main types of fofs as with any investment it s crucial to conduct due diligence before investing in a fof factors to assess include the fof s investment strategy managers track records fees liquidity and risks advantages and disadvantages of investing in fofsadditional diversificationaccess to premium investment opportunitiesprofessional managementsimplified investment processhigher expense ratiosthe risk of diluted returnscomplexity and risk of overlap in holdingsopaque nature of the investmentadvantages of investing in a fofinvesting in a fof provides several advantages that may appeal to a wide range of different investors individual and professional fofs come as either fettered or unfettered fettered fofs invest only in funds managed by the same company while unfettered fofs don t have to do so disadvantages of investing in a fofwhile fofs offer several benefits they also have drawbacks that investors should consider carefully multi strategy funds msfs vs fofsin the past decade many hedge funds have advertised offerings for multi strategy funds msfs a moniker that has spread to others 2 given that fofs were becoming known for excessive fees msfs seemed to some as putting new wrapping on an older idea 1 however while in some cases when multiple funds are being invested in this is true there are differences between msfs and fofs worth setting out a multi strategy fund has a single manager who oversees multiple investment strategies in most cases this shouldn t mean the manager is just average at many methods instead most multi strategy fund managers have achieved or employ those who have expertise in several strategies and rely on a team of specialists in each area the manager might have a background in one specific strategy say bonds but may incorporate new ones over time to increase the fund s capacity or capitalize on new prospects msfs are suitable for investors seeking a diversified portfolio with a single manager potentially lower fees and the ability to adapt to changing market conditions more quickly since all control is under one roof however it s easy to see the concern that a manager might not be up to handling different strategies simultaneously 2 thus fofs may appeal more to investors who value diversified exposure with multiple managers and are comfortable with potentially higher fees considerations for investors