A fund of funds is a type of investment instrument that makes investments in hedge funds, ETFs, and mutual funds. When you invest in a fund of funds, you instantly receive a fully diversified investment portfolio with broad exposure to a variety of asset classes and lower risk.
Workings of a Fund of Funds
Investors purchase shares in mutual funds, ETFs, and hedge funds, and fund managers invest the money, according to the investment strategy of the fund, in securities such as bonds and equities.
For instance, a fund that invests in short-term municipal bonds would use the funds from its investors to compile a portfolio of these bonds. This allows investors to spread their risk over a large number of different assets while still receiving the benefit of having a professional manager choose investments for them.
John Matina, co-founder and director of finance at PARCO, a startup aimed at assisting Americans in planning for retirement and managing their pensions, explains that a fund of funds is simply an iteration of this where instead of investing in a specific mutual fund, you are investing in a group of funds chosen, filtered, and selected by the fund of funds company.
According to Brent Weiss, CFP, co-founder of Facet Wealth, when you invest in a fund of funds, you’re essentially “hiring a general contractor” to conduct research on other managers, balance overall risk, and ensure the entire “project” goes well.
Types of Funds
There are plenty of funds available to fit a variety of investment aims and approaches. You can find either fettered funds, which only invest in funds held by the same management company, such as Fidelity or Vanguard, or unfettered funds, which invest in funds owned by any management company, in each distinct form of fund of funds.
Goal Date Funds
The most common kind of fund of funds, according to CFP Steve Athanassie, are target date funds.
According to Athanassie, these are generally built for retirement plans like 401(k) plans and are intended for participants who do not want to implement, monitor, or modify their investment mix. Target date funds are now available almost everywhere, from taxable investing accounts at major brokerages to workplace retirement plans.
When investors select a target date fund, their diversification and asset allocation are automatically adjusted as they come closer to their desired retirement date. This translates into target date funds beginning with a higher ratio of stock-based investments and subsequently shifting to a higher percentage of bond- and fixed-income investments as you get closer to retirement age.
Strategies for Allocating Targets
Some funds of funds focus on a specific asset allocation method rather than a specific date.
According to Weiss of Facet Wealth, “this strategy has a precise stock to bond weighting, such 60/40 or 80/20.” The mutual funds that make up the stock or bond allocation are subsequently chosen by a portfolio manager.
As long as the stock-to-bond ratio stays within the fund’s objectives, the portfolio manager has discretion regarding which funds to include, when to modify the investing strategy, and how to manage the portfolio over time.
Fund of Hedge Funds
The most difficult sort of investing to access is probably hedge funds. The SEC restricts them to only accredited investors with high incomes or net worths in exchange for the freedom to invest in more asset classes and give investors less transparency. Publicly listed hedge funds of funds go around this by enabling regular investors to invest in a diverse mix of expertly managed hedge funds.
When an investor has the ability to invest directly in a single hedge fund, diversifying among several funds is frequently preferred from the perspective of risk management, according to Athanassie. This can be facilitated and some of the manager and strategy risk can be reduced with the aid of a fund of various hedge funds. Hedge funds of funds do nonetheless take on far more risk than conventional index funds, but offering less risk than individual hedge funds, and typically also demand significantly higher fees.
Companies that Develop Businesses
Even though they have been established for about 40 years, business development companies (BDCs) are perhaps the least recognized (and understood) category of fund of funds, claims Athanassie.
BDCs are a sort of closed-end fund that invests in a collection of public or private businesses with market values under $250 million. BDCs frequently seek to assist struggling businesses regain a more stable financial position.
According to Athanassie, many of the businesses that BDCs invest in offer various types of finance for several other businesses. “For instance, one sizable BDC has a $2.6 billion portfolio and finances 147 various businesses. These businesses have access to a substitute for conventional bank loans through this BDC.
BDCs profit when the businesses they finance or invest in pay off debts or when the value of their stocks rises. Similar to REITs, BDCs are required to distribute nearly all of their income to shareholders, which makes them wealthy in dividend payments.
However, because BDCs invest in small, usually insolvent, infrequently traded businesses, they take on a lot of risk that ultimately affects your investment funds. Some BDCs are accessible to regular non-accredited investors since they are listed on a publicly traded market.