Most mutual funds and exchange-traded funds (ETFs) pool money from many investors and professionally invest it directly in a variety of assets based on the specific fund's investment description. Funds of funds (FoFs), however, invest in other funds rather than investing in individual assets.
While FoFs can provide broader diversification than investing in a single mutual fund or ETF, they also come with the potential for higher fees and other risks. Here are some factors to consider before investing in FoFs.
Potential Benefits of Funds of Funds
- Greater diversification than investing in a single mutual fund or ETF – FoFs typically invest across different types of assets, investment strategies, and countries or regions. This can provide broader market exposure, diversify risk and potentially lower the volatility, or general ups and downs, of your portfolio.
- Can be geared toward a specific goal – For example, certain target-date funds, also known as life cycle or life path funds, are FoFs that provide a simplified way to save for retirement. The allocation of investments within the target-date fund is generally set using your specified year of retirement, and the investment mix is automatically rebalanced to reduce risk as this date nears. Other funds, such as age-based portfolios used to save for higher education, might be well-suited for different goals.
- Access to specialized investment opportunities – FoFs can provide professional management that includes rigorous research, due diligence and specialized expertise across multiple asset classes and strategies, supported by continuous oversight. In addition, certain FoFs might offer exposure to specialized strategies, such as private funds, that might not otherwise be available to retail investors due to high investment minimums. Be aware that such specialized strategies might involve higher risk tolerances and longer investment horizons.
Risks of Funds of Funds
- Higher expenses that might result in lower returns – As FoFs invest in other funds, they generally have multiple layers of fees, often resulting in higher total costs. This can include expenses for the management of the FoF itself and for the underlying funds. These layered fees might impact returns over time. Use FINRA's Fund Analyzer to compare the fees and expenses of different FoFs and funds you're considering.
- Less transparency, which might limit your ability to assess risk – Because FoFs invest in underlying funds, investors might have less access or transparency into important factors, such as portfolio composition or underlying risks, that could impact your returns. For example, you might not be able to tell if several underlying funds hold the same investments--which could lead to concentration risk--or too many different investments--which could cause over-diversification. Similarly, FoFs that only invest in affiliated funds (funds that are part of the same fund family or investment company as a particular FoF) might face higher fees or weaker performance than similar products from nonaffiliated funds.
- Limited direct control over investments – With regular mutual funds or ETFs, you can choose a specific fund with a clear investment strategy and know exactly what securities you own. With FoFs, you invest in a fund that owns other funds--and those other funds own the actual securities. This makes it harder to choose exactly the type of investments you're getting exposure to. Also, FoFs have two layers of decision-making, which can impact market responsiveness. Regular mutual fund or ETF managers can directly buy and sell securities immediately in response to market changes. In contrast, FoF managers can decide to reallocate between funds and buy and sell shares of underlying funds, but FoF managers can't control what the underlying fund managers do with their funds' investments.
When evaluating investment products, consider working with an investment professional to help determine the best way to reach your financial goals.
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