A “fund of funds” is a term that refers to a portfolio consisting of mutual funds. The major advantage is that these types of portfolios can offer higher returns than individual stocks and bonds, due to the diversification factor. However, they also require large amounts of time and effort in maintaining them.
FoFs are sometimes referred to as “funds of funds” because the portfolios consist of funds. This is because each portfolio within a FoF consists of a group of mutual funds, and each fund held within the FoF has its own investment strategy. As such, there is no single holding or investment style that dominates all other stocks and/or bonds held within the portfolio.
In short: mutual funds are portfolios which contain a large number of shares (and therefore shares to buy and sell). The asset allocation for these portfolios relates to the types and/or amount of assets contained within these portfolios. Each mutual fund holds different types of investments. By holding several different mutual funds within one portfolio, an investor is able to diversify their holdings without the complications of trying to construct a portfolio themselves. A FoF is merely a collection of these mutual funds.
Why invest in FoFs?
Investors make use of FoFs for many reasons, not least because they can be quite advantageous; these include the fact that they do not necessarily retain any specific investment style (i.e. there are no restrictions on what securities go into them), they may allow investors to spread assets across multiple investments, and they also allow investors to diversify their assets across different types of funds (such as stock or bond funds). These advantages over direct stock and bond investing may result in enhanced returns, which can eventually lead to higher net wealth for investors.
But FoFs are not without their drawbacks! To list only a few: they require more time, effort and skill than simple investment strategies, they generate high transaction costs (which may eat away at the potential return), the investor must establish custody accounts for each of the securities contained within the portfolio, many times there are limits on what types of mutual funds can be held within a portfolio, and they also occasionally attract higher management fees.
What are the types of FoFs?
The three types of FoFs are equity funds, balanced funds and bond funds. Equity FoFs form the most commonly traded FoFs. These are also referred to as “funds of funds” because they are composed of mutual funds.
Bond FoFs are essentially similar to equity FoFs in terms of investment strategy, but they have a different investment objective. Unlike equity FoFs, who generally consist of mutual funds whose holdings can be varied within the portfolio, bond FoFs usually hold nothing but bonds. This is because the purpose of these portfolios is to hedge against risk in various ways, which means that an investor should possess only securities that are highly unlikely to default on their principal repayment obligations. Therefore, bonds are usually more appropriate for this type of portfolio.
Balanced FoFs are usually referred to simply as “balanced funds”, and are commonly used by investors who wish to invest in both stocks and bonds. Most balanced funds include a mix of bonds and equities, but this is not always the case. Most balanced funds will also include cash equivalents, commodities, real estate securities, foreign securities, derivatives, or any other security type that an investor can find! The most common investment objective for balanced FoFs is capital preservation with growth.
Are FoFs right for you?
A fund of funds (FoF) is a type of investment portfolio that consists of a group of various mutual funds. These types of investments are specifically attractive to those investors who wish to gain more diverse holdings, relative to those obtained from investing in individual stocks and bonds. However, the downside is that FoF investments require more time and effort on the part of the investor as compared with informal buying and selling. In some circumstances, the investment holdings may possess somewhat high fees – although this varies – which also affects performance for investors who invest in these products.