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Mutual funds can usually be defined by what type of asset they invest in or what kind of strategy they use to invest. Common names like “blue chip growth,” “small cap value,” “emerging markets,” and many others help investors understand what types of fund they are investing in and what they do. But funds of funds operate a little differently.
A fund of funds is a type of mutual fund that invests in other mutual funds. Whereas traditional mutual funds hold a portfolio that may consist of various stocks, bonds, and other assets, a fund of funds simply invests in the mutual funds themselves. The goal is to streamline the investment process for investors who just want a single fund instead of having to choose multiple funds and make allocation adjustments themselves.
The role of funds of funds in investor portfolios is growing. In 2017, total net assets of the U.S. mutual fund industry amounted to $18.75 trillion. Target-date funds, one of the most popular and fastest-growing segments of the fund of funds sector, reached $1.1 trillion – up a staggering 26% from 2016.
One of the biggest advantages that funds of funds offer compared to mutual funds is the level of professional management investors get. While mutual funds also have professional management when it comes to asset selection and allocation, not all management teams are equal. A fund of funds selects mutual funds based on certain criteria when it comes to how the fund is managed, such as length of tenure, track record, and other details that most investors don’t research fully.
Funds of funds do come with shortfalls, however. Expense ratios and fees are typically higher than those found in traditional mutual funds due to the extra layer of management investors receive. While the added diversification can be a boon for some investors, the extra expense negates gains they might otherwise have achieved.
One of the most common funds of funds that investors have access to is known as a target-date fund. This type of fund of funds is designed to adjust total portfolio allocations between equities and bonds through a collection of stock and bond funds as investors get closer to retirement. They may also be designed for investors who are already retired, such as the JPMorgan SmartRetirement Income Fund (JSRAX). It invests in other J.P. Morgan mutual funds and focuses on capital appreciation and income generation.
In the alternative investment arena, a fund of funds will invest in various hedge funds rather than mutual funds. Like the mutual fund industry, hedge funds come in many different forms and strategies, and the high initial cost to invest can make it difficult to choose more than one hedge fund. An alternative fund that invests in a group of hedge funds can be one way to gain exposure to multiple alternative investment strategies.
Management structures for funds of funds are designated as either fettered or unfettered. A fettered fund invests solely in other mutual funds offered by a single company, such as the earlier example of the JPMorgan SmartRetirement Income Fund. An unfettered fund doesn’t have the same restrictions and may freely mix and match mutual funds from a variety of investment companies to build the desired portfolio.
Interestingly, funds of funds were part of a bet between famed investor Warren Buffett and hedge fund Protege Partners. For $1 million, Buffett bet that a simple S&P 500 Index fund would beat the performance of five different funds of funds that Protege Partners chose over a 10-year time period beginning in 2007. The results were telling – the S&P 500 returned 7.1% compounded annually versus just 2.2% from Protege Partners’ selected funds of funds.
Learn here about how Alternative mutual funds are different from hedge funds.
Investors looking for a simple one-stop-shopping alternative to their investments might want to consider funds of funds, but higher performance can be attained by selecting an index fund that tracks the S&P 500 instead. Ultimately, risk tolerance is the best gauge for investors when it comes to picking an investment vehicle.
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