Strategic Investment Layering: The Fund of Funds Approach

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Some investors may see the term "fund of funds" as hyperbolic, on par with "king of kings" to describe a high-performing hedge or mutual fund. But that’s not entirely the case.

A fund of funds is just a group of separate funds combined into a single investment vehicle, which is often made accessible to investors of varying sizes.  A fund of funds is a pooled investment vehicle that allows investors to have diversified exposure to many asset classes with a single investment.

Keep reading if you want to add this type of investment layering to your investing portfolio!

 

Understanding Fund of Funds

A fund of funds, often called a multi-manager investment, is an investment vehicle whose investments consist entirely of portfolios from other funds.  Funds of funds are pools of capital that provide investors with greater security against losses but lower potential gains than direct investment funds.

Simply put, it's a collective investment fund that can replace individual investments in equities and bonds.

 

How Does Fund of Funds Work?

A fund of funds (FoF) invests in various funds managed by fund managers by purchasing shares with its cash.

When a fund invests in additional funds, it shares in the profits of other funds and distributes a portion of those earnings to its investors. By participating in such investment layering, investors can reduce risk over assets and they get exposure to markets.

Depending on the portfolio manager's skill, a fund of funds (FOF) investment may provide above-average returns. The degree of restriction placed on a FOF is negotiable.

- When a FOF can only invest in other funds offered by the same firm that runs the FOF, it is said to be "fettered,"

- But when it can invest in funds offered by other companies, it is said to be "unfettered."

 

Here is the list of the ten largest funds of hedge funds (FoF) for 2023 ranked by assets under management (AUM).


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*Source: https://hedgelists.com/top-25-fof-fund-of-hedge-funds-2023/

 

Types of Fund of Funds

Depending on their management style, underlying assets, or investment strategy, fund of funds can be of several types. Let’s take a look at these types.

- Hedge Fund of Funds- A hedge fund of funds is an investment vehicle that invests in a series of hedge funds. Hedge funds are financial vehicles that employ sophisticated techniques like leverage, short-term trading, and derivatives to earn profits.

- Private Equity Fund of Funds- A private equity fund of funds pools money from investors to invest in other private equity funds. Private equity funds seek to create a return on their investment by making strategic investments in privately owned firms to obtain a majority interest and enhance the company's operations.

- Real Estate Fund of Funds- A real estate fund of funds is a pool of capital that invests in other real estate investment vehicles, such as residential, commercial, or industrial real estate funds. To get diversity and possibly consistent returns via rental revenue and capital gain, investors might turn to real estate fund of funds.

- Venture Capital Fund of Funds- A venture capital fund of funds is a pool of cash that invests in other VC funds, all of which target high-growth startups in their early stages of development.

 

Benefits and Drawbacks of Fund of Funds

 

Benefits

Drawbacks

Expert Management Services

 

Over-diversification possibility

Due Diligence

 

Control and Transparency Issues

Portfolio Diversification

 

Performance evaluation and benchmarking

 

Explanation of above points given below.

 

Benefits Of FOF

 

Expert Management Services

Hedge funds are notoriously challenging for investors to evaluate because of the secrecy with which their asset allocation and investing methods operate. On the other hand, a Fund Of Funds acts as an investor's proxy. The portfolio manager is responsible for researching, selecting funds, and keeping tabs on their investments.

 

Due Diligence

Fund Of Funds uses a careful and structured due diligence process to find and hire investment managers with a history of successfully managing investment portfolios. Before hiring new fund managers, they conduct a comprehensive background check to determine if they have engaged in any activities that could harm the fund's performance.

 

Portfolio Diversification

A FOF invests in several different kinds of funds to spread out the fund's exposure to risk. With a single Fund Of Funds investment, even a small investor may have exposure to many asset classes, such as bonds, gold, stock, and debt. Such a diversified portfolio is unusual for a mutual fund.

 

Drawbacks of Fund of Funds

Over-diversification possibility- Over-diversification is a potential danger in a fund of funds, despite diversification's usually favorable reputation among investors. There is a risk of this happening if the underlying funds share assets or strategies since this might reduce the influence of individual selections and, hence, the opportunity for outperformance.

Control and Transparency Issues- Funds of funds may be less transparent and controllable than single funds since investors may need access to the core investments or the capacity to impact the investment choices of the primary fund managers.

Performance evaluation and benchmarking- To assess a fund of funds' efficiency, one must first understand the fund of funds' underlying investments, which may be a complicated and time-consuming process. It may make it hard for investors to have a clear picture of how their money is doing in the fund and whether or not it is achieving its goals.

 

Fund of Funds Fees Structure

Funds of funds have a multi-tiered fee structure that might reduce potential returns. Due to the cumulative fees involved, a FOF will be more expensive to maintain than a more conventional investment fund.

A fund of funds incurs management fees and running expenses on an ongoing basis, as well as a yearly operating expenditure. Investors in a fund of funds (FOF) pay more since each component fund has its own expenses and management fees.

Simply put, the fund of funds levy a 1% annual management fee in addition to the underlying funds' 1% annual management fee. As a result, the yearly cost might rise to as much as 2%.

 

Investing in Fund-of-Funds

Research is a good resource for learning about the type of fund categories. You may locate and then evaluate your possibilities using its investing tools, which include databases and fund screeners.

After narrowing your search, compare the funds' ratings, cost ratios, and internal fund ratings to find the best option. Then, use your broker to purchase shares in your mutual fund or exchange-traded fund.

If utilized correctly, a fund of funds is an effective asset allocation and diversification instrument.

 

Maximize your Investment potential with tools.

Investors should exercise caution when considering investments in funds of funds, despite the temptation to dive headfirst into a fund that promises massive returns. Understanding the possible rewards, risks, and regulatory concerns of investing in or operating a fund of funds is crucial.

Many high-end software offer robust tools and services that might be useful in navigating this investing plan. The state-of-the-art technology and straightforward interface make it simple to manage your fund of funds, monitor your investments, and make intelligent choices that will help you earn the highest possible returns. Try software to guide your investing process to ensure your portfolio experiences considerable growth and stability. 

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