Fund-of-Funds

A fund-of-funds is an investment fund whose portfolio consists of holdings in other funds. Its manager does not pick individual shares, bonds or companies; the manager selects other fund managers, decides how much to allocate to each, and monitors them. The investor obtains exposure to many underlying funds, and through them to a very large number of investments, by making one commitment or buying one unit.

The structure is used across the industry. Retail multi-manager funds invest in mutual funds and exchange-traded funds; funds of hedge funds spread capital across trading strategies; and private market funds-of-funds commit to private equity, venture, credit and real asset funds. It is distinct from a feeder fund, which channels money into a single master fund.

The manager begins with an allocation plan: which strategies, regions and styles to hold and in what proportions. It then carries out due diligence on candidate funds, looking at the team, the investment process, the track record, operations, the service providers and the terms. Operational review matters as much as investment review, since many fund failures have been failures of control and not of strategy.

Once invested, the manager monitors performance and risk, rebalances between funds and replaces those that disappoint. The fund-of-funds is itself a regulated or private fund with its own administrator and custodian, and its net asset value depends on the prices reported by the underlying funds. Where those funds report monthly or quarterly, the fund-of-funds prices with a lag and may rely on estimates.

• Multi-manager and multi-asset funds. These hold listed funds and offer a ready-made asset allocation for savers and pension plans. Target-date retirement funds are commonly built this way, often using funds from the same manager, a structure sometimes called fettered.
• Funds of hedge funds. These give access to managers with high minimum investments and aim to smooth returns by combining strategies. They must match their own redemption terms to the notice periods and lock-ups of the funds they hold.
• Private equity funds-of-funds. These make a limited partner commitment to a series of buyout, growth or venture capital funds over several years and across managers, which spreads vintage risk. Many also buy existing fund interests through a secondary fund transaction or invest directly alongside managers.

The investor pays fees at two levels. The underlying funds charge their own management fee and, in alternative strategies, a performance fee or carried interest. The fund-of-funds adds its own management fee and sometimes a smaller performance fee on top. The combined cost can be substantial, and regulated funds must disclose it, usually as acquired or underlying fund expenses within the ongoing charge.

Other frictions follow from the layering. Performance fees are paid to each underlying manager that does well even if the overall portfolio loses money, because gains and losses are not netted between managers. Diversification across many funds can reduce returns towards the market average while fees remain. Liquidity is only as good as the least liquid layer, and investor reporting is slower.

For smaller institutions, family offices and individuals, a fund-of-funds provides access, selection skill and administration that would be costly to build. Minimum commitments to leading private funds are large, and a single commitment to a fund-of-funds may reach twenty or more managers. It also outsources the work of handling each capital call and distribution, legal review of fund documents and ongoing monitoring. Large investors with their own teams tend to invest directly, and some have moved away from funds-of-funds for cost reasons, using advisers or separately managed mandates instead.

Fund rules limit how regulated funds may invest in other funds. In the European Union, a UCITS may invest in other funds subject to concentration limits and restrictions on the target funds' own fund holdings, which prevents long chains of funds investing in each other. In the United States, the Investment Company Act limits how much of another registered fund a fund may acquire, with exemptions that were consolidated in a fund-of-funds rule adopted by the Securities and Exchange Commission in 2020.

The collapse of Bernard Madoff's firm in 2008 exposed funds of hedge funds that had placed client money with a single manager through feeder structures, and showed that due diligence was not always as thorough as marketed. The episode, together with poor returns in the financial crisis and suspended redemptions, led to a sharp fall in assets managed by funds of hedge funds in the years that followed.