Fund of Funds

What is a Fund of Funds?

Well, you’ve all heard of the benefits of diversification thanks to Mr Markowitz. For the financially illiterate, investing is undoubtedly going to be a very difficult task. That’s why fund managers exist – to take your money and do all that financial nonsense for a handsome fee.

But how can you tell which fund manager will perform the best?

Well, if you don’t want to put all your faith in a single person, why not invest in a bunch of them. That is exactly what a fund of funds is for. Fund of Funds allows for broader diversification by holding a portfolio that contains different underlying portfolios of other funds. These holdings replace any investing directly in bonds, stocks, and other types of securities. Instead, these fund of funds will invest in other mutual funds or hedge funds.

FOF’s can be “fettered” meaning only investments are made only on funds run by the company itself, or “unfettered” meaning investments can be made in funds across the entire market.

Advantages and Disadvantages

Advantages

Fund of funds allow small investors access to high minimum funds, such as hedge funds which typically have minimum investments of 6 figures and require investors to have a minimum net worth. Small investors, who do not typically have access to such investments are therefore able to get better exposure to assets and further diversify their portfolio. The diversification within a fund of funds also has a reduced level of risk and has less exposure to market volatility, benefiting the investor.
Furthermore, the FOF managers are typically experienced fund managers who typically stem from a good background and have good credentials in the security industry. Theoretically, the extensive research on the initial underlying investments by the managers add an additional layer of protection.

Disadvantages

At the same time, selecting market beating fund managers who are able to generate good returns is costly. The company or companies (depending on whether your funds are fettered or unfettered) charge high annual management and incentive feeds, and often pass through the feeds from the underlying funds. These fee burdens make it difficult for the FOF to generate good returns for the investor.
Additionally whilst the diversification in the portfolios also produce lower, more average returns. It is also difficult to monitor the overall holdings of a fund of funds due to limited knowledge of the underlying investments of selected funds.

Case Study

Perhaps the most infamous Fund of funds was the first one ever, created by Bernie Cornfeld in 1962.

Cornfeld began his career in the 50’s as a mutual fund salesman. In 1956, he moved to Paris to sell popular American mutual funds to Americans living abroad. This was the beginning of Investors Overseas Services (IOS), a company that would end up short-lived. Cornfeld was well-known for his catchphrase “Do you sincerely want to be rich?”.

In the following decade, he raised 2.5 billion overseas dollars for the company’s fund which was coined “people’s capitalism” by the founder Cornfeld. Cornfeld distributed the money to managers like Fred Alger to run funds owned by the company. The company’s operations were often at the edge of the law which attracted the attention of the SEC. The SEC filed a complaint in 1965 accusing the IOS of violating American Securities Law. This complaint was settled in 1967 with the IOS agreeing to sell all of its American operations and buying no more than 3% of any American mutual fund. Share value continued to decrease drastically as investors continued to cash out. The company was finally crippled when financier Robert Vesco looted 500 million of IOS’s funds to cover his own investments.