In 1996, there were 45 "funds of funds" on the market, according to the Investment Company Institute, a trade organization for the mutual fund industry. By 2005, that number had swelled more than tenfold, to 475; and last year, there were 865 funds of funds. Clearly, they're increasingly finding favor with investors.

But are they for you? Well, perhaps. A review of what they are and what they offer might shed some useful light on the question.

What you're buying
As you may have suspected, a fund of funds is a mutual fund that invests in other funds. In some cases, these other funds are hedge funds, and the fund of funds can thereby make hedge-fund investing more accessible to smaller investors. Very often, though, a fund of funds is invested in an array of regular mutual (or index) funds.

For example, the Pearl Aggressive Growth (PFAGX) fund recently had about 19% of its assets in the Matthews Pacific Tiger (MAPTX) fund, 18% in the Kinetics Small Cap Opportunities (KSCYX) fund, and 15% in the Fidelity Leveraged Company Stock (FLVCX) fund, among others.

Very often, though, you may not want all the component funds, and the ones you don't want will dilute the power of the ones you do. For example, consider the Fidelity fund in the Pearl Aggressive Growth fund. The table below shows you some of its recent top holdings. You can see that a stock that makes up 3% of the Fidelity fund will make up only a little more than half a percent of the overall fund of funds. So your money is really being spread thin, and you may actually end up overdiversified.

Company

CAPS Stars
(out of 5)

% of the Fidelity Fund

Share of Overall
Fund of Funds

Freeport-McMoRan Copper & Gold (NYSE:FCX)

****

5.74%

0.88%

El Paso (NYSE:EP)

****

3.00%

0.46%

PNC Financial (NYSE:PNC)

**

1.89%

0.29%

Tenet Healthcare (NYSE:THC)

***

1.89%

0.29%

Flextronics (NASDAQ:FLEX)

****

1.64%

0.25%

Comcast (NASDAQ:CMCSA)

**

1.28%

0.20%

Wells Fargo (NYSE:WFC)

***

1.18%

0.18%

Data: Morningstar.

Note that this assumes that none of the other funds owns these stocks. Often, though, you will have some duplication, and if you do, the value of owning a fund of funds diminishes.

What to do
Don't dismiss all funds of funds. Some, like "lifecycle" or "target-date" funds that tweak their holdings over time to reflect your approach to retirement, can be useful, although they can have their own problems.

But consider just building your own fund of funds in your portfolio. Buy exactly the funds you want to own, and no more or less. You'll probably pay less in fees by cutting out the middleman, and your performance might benefit, too.

Longtime Fool contributor Selena Maranjian owns shares of the Matthews Pacific Tiger and Fidelity Leveraged Company Stock funds. Try any of our investing newsletter services free for 30 days. The Motley Fool is Fools writing for Fools.