Fund of funds: how they work & benefits
Investing in private markets can be complex, particularly when considering how to build a diversified portfolio across multiple funds with multiple managers and strategies. A fund of funds (FoF) offers an alternative route, providing access to a range of underlying funds (and consequently their underlying investments) through a single vehicle.
This approach can be particularly valuable for investors seeking thoroughly diversified exposure to private equity or other alternative assets without the operational burden of managing multiple relationships or the administration that comes with these investments.
What is a fund of funds?
A FoF is an investment vehicle that holds a portfolio of other investment funds rather than investing directly in individual companies, bonds or other securities. Rather than selecting and managing individual assets, the FoF approach pools capital from investors and allocates it across multiple underlying funds, each managed by specialist fund managers.
This structure is common across various asset classes, including private equity, hedge funds and even traditional mutual funds. For investors, it provides a way to access diversified investment strategies through a single commitment, whilst benefiting from the expertise of multiple fund managers operating in different markets or sectors.
How a fund of funds works
The mechanics of a FoF are straightforward. Investors commit capital to the FoF manager, who then selects and invests in a portfolio of underlying funds. These underlying funds might focus on different sectors, geographies, strategies or stages of company development.
The FoF manager conducts due diligence on potential underlying funds, monitors their performance and makes allocation decisions based on market conditions and investment objectives. This layer of oversight aims to identify high-quality managers and construct a portfolio that balances risk and return across multiple investments.
Investors receive exposure to all the underlying funds through their single investment in the FoF. Distributions from the underlying funds flow through to the FoF investors, typically after the deduction of management fees at both levels.
Types of fund of funds
Private equity fund of funds
A private equity FoF invests in multiple private equity funds, which in turn acquire stakes in private companies. These FoF can focus on specific strategies such as buyouts, growth equity or venture capital, or they may span multiple strategies to provide broader exposure to private markets. For investors, a private equity FoF offers access to a range of private equity investments that might otherwise require substantial capital commitments and operational resources to manage directly.
Hedge fund of funds
Hedge FoF allocate capital across multiple hedge fund managers, often employing diverse strategies such as long-short equity, event-driven investing or global macro approaches. The FoF manager seeks to construct a portfolio that balances these strategies, aiming to generate returns whilst managing volatility. This type of FoF became particularly popular among institutional investors seeking diversified hedge fund exposure without the need to conduct extensive due diligence on individual managers.
Benefits of investing in a fund of funds
Diversification
The primary advantage of a FoF is diversification. By investing in multiple underlying funds, investors gain exposure to a broader range of assets, strategies, sectors and geographies than they might achieve through a single fund. This diversification can help reduce the impact of any single manager's underperformance or any particular market segment's weakness.
For private equity investors, this means exposure to companies at different stages of development, across various industries and potentially in different regions. The result is a more balanced risk profile compared to concentrating capital with a single manager or strategy.
Less capital required to achieve diversified exposure
Funds have minimum investment levels that investors need to meet in order to be able to invest in them. A FoF structure means a single investment and only one minimum investment level to meet. This means investors can achieve greater diversification with less capital outlay than investing in the individual funds separately.
Professional management
FoF managers bring specialist expertise in selecting and monitoring underlying funds. They conduct thorough due diligence, assess manager quality and track performance across their portfolio. This professional oversight can be valuable for investors who lack the resources or expertise to evaluate multiple fund managers themselves.
The FoF manager also handles the administrative burden of maintaining relationships with multiple underlying funds, processing capital calls and distributions, and providing consolidated reporting to investors.
Access to exclusive investment opportunities
Many high-quality private equity and hedge funds are closed to new investors or require substantial minimum commitments that place them beyond the reach of most individual investors. FoF managers often have established relationships with these sought-after managers and can secure allocations on behalf of their investors. This provides access to investment opportunities that would otherwise be unavailable, particularly for those new to alternative investment funds.
Risks of investing in a fund of fund
Higher fees
The most frequently cited drawback of FoF is the fee structure. Investors pay fees at two levels: to the underlying funds and to the FoF manager. This double layer can erode returns, particularly when underlying performance is modest. Investors need to consider whether the benefits of diversification and professional management justify these additional costs.
Over-diversification
While diversification is generally beneficial, it’s possible to have too much of it. A FoF holding stakes in dozens of underlying funds may become so diversified that it effectively tracks the broader market or asset class average. This over-diversification can dilute the potential for outsized returns that might be achieved by concentrating capital with a smaller number of high-performing managers.
Additionally, as the number of underlying holdings increases, the FoF manager's ability to conduct thorough due diligence and monitoring may be stretched, potentially compromising the quality of manager selection.
Unclear nature of an investment
The layered structure of a FoF can make it difficult for investors to understand precisely what they own. With multiple underlying funds each holding portfolios of individual assets, transparency can be limited. Investors may receive only high-level information about the FoF’s allocations, with limited visibility into the specific companies or assets held within the underlying funds.
This lack of transparency can make it challenging to assess risk, understand correlation between holdings, or evaluate whether the FoF aligns with broader portfolio objectives.
Who are fund of funds suitable for?
FoF can be appropriate for investors who want exposure to private markets or alternative strategies but lack the capital, expertise or resources to build a diversified portfolio of direct fund investments themselves. They may be particularly suitable for those making their first allocation to private equity or hedge funds, as the diversified structure can help mitigate the risk of backing an underperforming manager.
However, investors should carefully consider the fee structure and assess whether the benefits justify the costs. Those with sufficient capital and expertise may prefer to invest directly in individual funds to avoid the additional layer of fees.
Understanding why to invest in alternatives is an important step in determining whether a FoF approach aligns with your investment objectives.
Conclusion
A FoF provides a route to diversified exposure across multiple investment managers and strategies through a single vehicle. For investors seeking access to private equity FoF or other alternative investments, this structure offers professional management, reduced concentration risk and potential access to exclusive opportunities that might otherwise be unavailable.
However, the double layer of fees and the potential for over-diversification are important considerations. The decision to invest in a FoF should be based on a clear assessment of your investment objectives, available capital and tolerance for the additional costs involved. As with any investment of this nature, there is risk to the capital invested and no guarantee of returns, which investors also need to bear in mind.
If you're considering alternative investments, we encourage you to explore understanding alternatives to build your knowledge and make informed decisions about your portfolio strategy.
Important note
Alternative investments are high risk and speculative which means there is no guarantee of returns and investors should not invest unless they are prepared to lose all of their money. Past performance is not a reliable indicator of future performance. This type of investment is typically medium to long term and illiquid so can’t be easily accessed until the exit point. The investor may not be protected if something goes wrong.