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A "fund of funds" (FOF) is an investment strategy of holding a portfolio of other investment funds rather than investing directly in stocks, 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 but the original Fund of Funds was created by Bernie Cornfeld in 1962. It went bankrupt after being looted by Robert Vesco.
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.
Pension funds, endowments, 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 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. 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.
The fund-of-funds structure may be useful for asset-allocation funds, that is, an "exchange-traded fund (ETF) of ETFs" or "mutual fund of mutual funds". For example, iShares has asset-allocation ETFs, which own other iShares ETFs. Similarly, Vanguard has asset-allocation mutual funds, which own other Vanguard mutual funds. The "parent" funds may own the same "child" funds, with different proportions to allow for "aggressive" to "conservative" allocation. This structure simplifies management by separating allocation from security selection.
A target-date fund is similar to an asset-allocation fund, except that the allocation is designed to change over time. The same structure is useful here. iShares has target-date ETFs that own other iShares ETFs; Vanguard has target-date mutual funds that own other Vanguard mutual funds. In both cases, the same funds are used as the asset-allocation funds. Since a provider may have many target dates, this can greatly reduce duplication of work.
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 funds investment managers is based on information published by Private Equity Intelligence:
Source: Preqin (formerly known as Private Equity Intelligence)
According to 2011 Preqin Global Private Equity Report, largest firms by total fund of funds capital raised in the last 10 years ($bn) are:
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 exchange-traded fund (ETF).
A study of hedge fund returns from 1998 to 2010 by Simon Lack shows very poor performance compared to the market. From 1998 to 2010, the index (of hedge funds) returned only 2.1% annualized on a money-weighted basis. Hedge fund managers earned $379 billion in fees, while investors earned only $70 billion in profits. Thus, the operators earned 84% of the investment profits and investors only 16%. Funds of hedge funds, which add another layer of fees, did even worse. Including these brings industry fees up to $440 billion, or 98% of the profit pool, leaving only $9 billion for investors.
“While the hedge fund industry has generated fabulous wealth and created many fortunes, it has largely done so for itself.”
— Simon Lack
An early fund of funds were 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.
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.