Index funds are an easy, low-cost way to get diversified. Are they right for your portfolio?
What is a fund of funds?
A fund of funds, or FOF, is a pooled investment holding other funds, such as mutual funds or hedge funds, rather than individual stocks, bonds and other securities.
The goal of the fund of funds is to achieve broad diversification and asset allocation with a variety of funds that are bundled into one fund. FOFs often attract smaller investors who want broader investment exposure while achieving less risk than by investing directly in the securities.
FOFs, also known as multi-manager investments, can be costlier than other investments. The investor can end up paying operating expenses for the underlying funds as well as the FOF’s.
Previously, a fund of funds didn’t always disclose the underlying fund expenses. However, in January 2007, the Securities and Exchange Commission began requiring the fees be disclosed in the “acquired fund fees and expenses” line. After accounting for the additional operating expenses, the return FOFs offer may be lower than other single investments.
The benefits of FOFs are that they provide the investor with professional financial management. FOFs also allow small investors to benefit from a diversified portfolio with minimal investment.
Also, FOFs managers are required to maintain certain credentials within the securities industry. These rules are in place to protect investors.
Fund of funds example
Jake has $5,000 to invest. He wants the exposure of stocks and bonds but also wants to limit his risk. He invests in a mutual fund FOF. This investment consists of several mutual funds that are bundled together and invests in a variety of stocks and bonds.
Although Jake doesn’t have a large sum of money, this investment is enabling him to still diversify his portfolio while maintaining lower risk. Jake also is benefiting from professional management.
Still, Jake is paying higher fees than he would with a traditional mutual fund. This is because he’s being charged 1.5 percent interest for the operating expenses in the underlying fund and 1.25 percent interest in operating expenses for the fund of funds. This higher expense ratio lowers Jake’s return.
Should you invest in a mutual fund or an ETF? Learn about the tradeoffs of each investment.