A "fund of funds" (FOF) is an investment strategy of holding a portfolio of other investment funds rather than investing directly in shares, bonds or other securities. This type of investing is often referred to as multi-manager investment. A fund of funds may be 'fettered', meaning that it invests only in funds managed by the same investment company, or 'unfettered', meaning that it can invest in external funds.
There are different types of 'fund of funds', each investing in a different type of collective investment scheme (typically one type per FoF), for example 'mutual fund' FoF, hedge fund FoF, private equity FoF or investment trust FoF.
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Investing in a collective investment scheme may increase diversity compared to a small investor holding a smaller range of securities directly. Investing in a fund of funds may achieve greater diversification. According to modern portfolio theory, the benefit of diversification can be the reduction of volatility while maintaining average returns. However, this is countered by the increased fees paid on both the FoF level, and of the underlying investment fund.
An investment manager may actively manage with a view to select the best securities. A FoF manager will try to select the best performing funds to invest in based upon the managers past performance and other factors. If the FoF manager is skillful, this additional level of selection can provide greater stability and take on some of the risk relating to the decisions of a single manager. As in all other areas of investing, there are no guarantees for regular returns. As a fund of funds invests in the scheme of other funds, it provides a greater degree of diversification. Instead of investing in different stocks of mutual funds and keeping records of all of them, it is much easier to invest and track only one fund which in turn invests in other mutual funds.
Management fees for Funds Of Funds are typically higher than those on traditional investment funds because they include the management fees charged by the underlying funds.[1] As in the case of schemes of mutual funds, FOF schemes also work under the due diligence of a fund manager. This gives the scheme an additional expertise. It also helps to provide access to information which may be difficult to obtain information by an investor on a case by case basis. Every fund manager has a particular style of diversification. This diversification has a perfect correlation with the number of managers involved. Once a FOF reached a certain level of managers, adding more flattens return curve and diversifies away alpha (Harry Prasun Kat2). Since a fund of funds buys many different funds which themselves invest in many different securities, it is possible for the fund of funds to own the same stock through several different funds and it can be difficult to keep track of the overall holdings.
Funds of funds are often used when investing in hedge funds and private equity funds, as they typically have a high minimum investment level compared to traditional investment funds which precludes many from investing directly. In addition hedge fund and private equity investing is more complicated and higher risk than traditional collective investments. The lack of accessibility favors a FoF with a professional manager and built-in spread of risk.
Pension funds and other institutions often invest in funds of hedge funds for part or all of their "alternative asset" programs, i.e. investments other than traditional stock and bond holdings.
After allocation of the two levels of fees payable and taxation, returns on FoF investments will generally be lower than single-manager funds.
The due diligence and safety of investing in FoFs has come under question as a result of the Bernie Madoff scandal, where many FoFs put substantial investments into the scheme. It became clear that a motivation for this was the lack of fees by Madoff which gave the illusion that the FoF was performing well. The due diligence of the FoFs apparently did not include asking why Madoff was not making this charge for his services.[2] 2008 and 2009 saw fund of funds take a battering from investors and the media on all fronts from the hollow promises made by over-eager marketers to the strength (or lack) of their due diligence processes to those carefully explained and eminently justifiable extra layers of fees, all reaching their zenith with the Bernie Madoff fiasco.[3]
According to Preqin (formerly known as Private Equity Intelligence), in 2006 funds investing in other private equity funds (i.e., fund of funds, including secondary funds) amounted to 14% of all committed capital in the private equity market. The following ranking of private equity fund of fund investment managers is based on information published by Private Equity Intelligence:
Source: Preqin (formerly known as Private Equity Intelligence)[4]
According to 2011 Preqin Global Private Equity Report, largest firms by total fund of funds capital raised in the last 10 years ($bn) are:
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Source: Preqin[5]
A fund of hedge funds is a fund of funds that invests in a portfolio of different hedge funds to provide broad exposure to the hedge fund industry and to diversify the risks associated with a single investment fund. Funds of hedge funds select hedge fund managers and construct portfolios based upon those selections. The fund of hedge funds is responsible for hiring and firing the managers in the fund. Some funds of hedge funds might have only one hedge fund in it, this lets ordinary investors into a highly-acclaimed fund, or many hedge funds.
Funds of hedge funds generally charge a fee for their services, always in addition to the hedge fund's management and performance fees, which can be 1.5% and 15-30%, respectively. Fees can reduce an investor's profits and potentially reduce the total return below what could be achieved through a less expensive mutual fund or ETF.
While funds of funds conceptually can provide extremely useful services for many hedge fund investors, they have been criticised for the significant incremental costs they impose. (The underlying hedge funds usually charge fees of between 1 and 2% of assets managed and incentive fees of 15–25% of profits generated. The funds of funds typically add additional fees of 1% and 10%, respectively). Moreover, fund-of-funds behavior has often exhibited crowd-following tendencies, suggesting the managers of these funds prefer to match indices rather than seek opportunities.
The industry has recently been criticized by some hedge fund managers for a reputation of holding a short-term view. Some hedge funds have even started turning away fund of hedge funds money. “It is really beginning to irritate those funds of hedge funds that approach their investments sensibly,” says one fund of hedge funds manager.[6]
The first fund of funds was started by the Rothschild family in Europe in 1969 under the name Leveraged Capital Holdings. In 1971, Richard Elden founded Grosvenor Capital Management in Chicago, Illinois, introducing the concept of fund of funds to the United States.[7]
A fund of venture capital funds is a fund of funds that invests in a portfolio of different venture capital funds to access to private capital markets. Clients are usually university endowments and pension funds.[8]
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