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Looking for a vehicle to broadly diversify investments while mitigating risk? Launching a Fund of Funds might be for you.
Here at Fund Launch, we’ve helped over 300 funds launch. We know the ins and outs involved, and we’re here to break it down for you today.
Below, you’ll gain a working understanding of Fund of Funds (FoFs), how they’re structured, what types are available, whether launching one is right for you, and how we can help you get started.
What is a Fund of Funds?
A Fund of Funds (FoF) pools capital from multiple investors to invest in a variety of investment funds, often from different asset classes.
Just as investing in a portfolio of stocks lowers risk because investors aren’t sinking all their investment capital into one stock option, so investing in FoFs further lowers risk by allowing broader exposure to many different asset classes.
Though returns may sometimes prove lower, they are, on the whole, much more stable, and therefore, in the long run, a lucrative option for fund managers. Perhaps best of all, FoF managers can rely on the expertise of other fund managers rather than try to become an expert in every funding niche themselves.
How a Fund of Funds Works
Those who choose to invest in a standard fund are already diversifying their investment; however, they’re still only investing in one asset class, whether private equity, venture capital, or something else.
A FoF, however, invests in multiple funds, often from different asset classes.
Benefits of investing in a FoF include:
- Greater investment opportunities
- Broader diversification
- Reduced risks
The role of the FoF manager is to select which funds to invest in on their investors’ behalf: hedge, exchange-traded, mutual, private equity, multi-manager funds, Business Development Companies (BDCs), and others.
The investors’ ability to lean on the expertise of a FoF manager is a huge advantage, granting them a “set it and forget it” privilege that might be unavailable to them otherwise.
While this additional layer of management grants investors access to an even greater depth of knowledge and skill, it also comes at a cost. The extra layer of management leads to a double layer of fees: the fees charged by the underlying funds and the fees imposed by the FoF manager.
Structure of a Fund of Funds
Before setting up a FoF, you’ll need to understand some basics about their structure, how to layer investments, and the layers of fees involved.
Basic FoF Structure
Each FoF is overseen by a fund manager. The role of the manager is to oversee the FoF, select underlying funds to add to the portfolio, conduct due diligence, make informed investment decisions, and make regular reports to investors.
The underlying funds in the FoF are, in turn, each managed by their own fund managers. Because of this, FoFs are sometimes referred to as “multi-manager funds.”
FoFs can be “fettered” (the fund of funds only invests in funds from one investment company) or “unfettered” (the fund of funds invests in any funds on the market).
Layering of Investments
The unique structure of a FoF creates a natural layering effect with distinct benefits by allowing fund managers to allocate capital across various underlying funds.
This creates a highly diversified portfolio requiring much less research on the front end, since managers are not spending their time researching individual investment options.
When determining which funds to invest in, FoF managers should:
- Diversify without spreading too thin. By investing in varying underlying funds, managers can create an investment bundle that greatly mitigates risk and covers any underperforming funds. Investing too widely, however, comes with its own downsides, such as spreading the FoF too thin.
- Keep all capital engaged. Never sit on investment capital. Instead, investing in short-term, high-yield vehicles is your best option.
- Monitor your bundle. Managers have a responsibility to monitor their funds and adjust whenever necessary.
For example, good FoF managers will conduct due diligence and build a portfolio including different types of assets, strategically diversifying to combat potential volatility. If they notice one of their funds consistently underperforming over time, they will pivot and decide the next best course of action.
Management Fees
Like the layered structure of FoFs, the fee structure is also layered. In addition to the fees of underlying fund investments, there’s an extra layer of FoF fees.
- Management fees: FoF managers generally charge anywhere from .5%-2% annually, regardless of returns.
- Performance fees: Performance fees are calculated based on positive returns. These can fall anywhere between 5%-20%.
In order for managers to earn performance fees, they must meet a minimum return, often referred to as a “hurdle rate.” When calculating performance fees, the percentage of the hurdle rate is typically subtracted from the overall percentage of return.
For example, if a FoF enjoys 12% growth with a hurdle rate of 3%, the performance fee would be calculated based on the 9% difference.
Though this multi-layered structure leads to higher fees, this is offset by the lower risk and higher reward.
Types of Funds of Funds
Like individual investments, FoFs come in all shapes and sizes. Based on differing needs, risk preferences, and investment objectives, different types of FoFs will appeal to different investors.
- Multi-Manager Funds: As the title indicates, Multi-Manager FoFs have multiple managers managing different portions of the FoF. For example, one manager may manage hedge fund investments, while another manages private equity fund investments. Their target investor is likely an individual with a high net worth who already invests in funds but is seeking to further diversify.
- Funds of Hedge Funds: These FoFs develop specific themes and strategies around investing in hedge funds. Target investors can afford a high-cost investment and have a high risk tolerance.
- Business Development Companies: BDCs are closed-end development companies, some of which are private and some publicly traded. They tend to invest in small and medium-sized private companies that have the potential for high yields, typically during the earlier stages of development. BDCs tend to attract small, non-accredited investors, retail investors, and small-growth companies.
- Other options: Many other FoF options exist, such as FoFs made up of mutual funds, bond funds, private equity funds, venture capital funds, and other investment funds.
Benefits of a Fund of Funds
FoFs come with three distinct benefits.
Diversification
Because of their unique, layered structure FoFs allow investors to invest in more funds for a single investment cost.
Likewise, they allow fund managers access to the type of diversification that can better ensure the success of their fund of funds.
Risk Mitigation
Thanks to the two layers of professional management and the broad exposure across asset classes, sectors, and geographical regions, investing in a FoF can greatly reduce individual, fund-specific risks.
For the FoF manager, the associated lowering of risk factors can naturally lead to less stress and greater peace of mind.
Access
Because of the nature of their structure, FoFs can grant individual investors access to exclusive or otherwise difficult-to-invest-in funds that they might not be able to access directly.
Some funds, for example, set high minimum investments that would normally bar some individual investors from entry. When investing through a FoF, however, investors can skirt the minimum-investment requirement and enjoy a buy-in.
Drawbacks and Considerations
FoFs are not without their drawbacks, however.
Higher Fees
We’ve already outlined the double layer of fees associated with investing in a FoF. Depending on how much someone invests and the potential return, this double layer of fees can lead to a FoF having a higher expense ratio.
Unfortunately, this means that even if your FoF sees a high rate of return, these fees can actually erode returns over time, a fact that might deter the more savvy investors.
Complexity and Lack of Transparency
While managing a FoF ostensibly comes with lower risks, one downside for managers is the complexity involved in selecting and monitoring the underlying funds.
This same complexity impacts investors, who may find the double layer of research involved in determining if they want to invest in the FoF a hurdle. When investors look to invest directly in an asset category, they find it easier to do their own due diligence. Investing in a FoF, however, is a different story, and this lack of transparency could potentially deter some investors.
Diluted Returns
While diversification does come with the advantage of lower risks, one potential downside is that low-performing funds could bring down the performance of high-performing funds, affecting returns on the whole portfolio.
This could make some investors wary of investing in a FoF, particularly if they are already invested in one or more of the underlying funds and unimpressed with its current level of returns.
Fund of Funds vs. Direct Investment
Before launching a FoF, it’s good to weigh your options.
Given your goals, would it be wiser to focus on launching a FoF or sticking with a direct investment model?
Fund of Funds
Pros to managing a FoF:
- Surprisingly low-maintenance after the initial launch
- Good returns and more peace of mind
Cons to managing a FoF:
- Unique challenges to the launch process
- Fund manager doesn’t have direct control over the assets
- Higher fees associated with this model can deter some investors
Direct Investment/Standard Fund Model
Pros of the Standard Fund Model:
- Potentially lower fees for investors
- More control over individual investment choices for the fund manager
Cons of the Standard Fund Model:
- Managing a diversified portfolio directly takes significantly more time
- A higher level of expertise is required
Scenarios for Each Approach
Depending on your current needs, experience, or situation, either choice might be right for you.
When making your decision, take these factors into consideration, both for yourself and your investors:
- Current levels of knowledge and experience
- Current risk tolerance
- Current investment goals
Your answers to these key considerations will bring you closer to a decision.
Steps to Launching a Fund of Funds
Step 1: Initial Planning
Always take time first to define the investment strategy and objectives of your FoF. This task goes hand-in-hand with creating a target investor profile.
To create a target investor profile, summarize their likely:
- Financial goals
- Current financial situation
- Time horizon
- Risk tolerance
Knowing what will attract investors to your FoF will tell you who your investors are, and knowing which investors you’re hoping to target will help you build your ideal FoF.
Step 2: Legal and Regulatory Compliance
Learning the legal structures and regulatory compliance for launching a FoF is absolutely essential. The SEC has strict guidelines for Fund of Funds, and working with legal and financial advisors to ensure compliance is absolutely essential.
This process can feel overwhelming, but Fund Launch can assist with legal compliance!
Step 3: Due Diligence
Always conduct due diligence on potential underlying funds.
Consult an expert or access a comprehensive template or checklist for fund managers and make sure you are covering all your bases in selecting only the most reputable and high-performing funds.
Step 4: Ongoing Management
While launching a fund of funds requires quite a bit of front loading, managing your FoF still requires ongoing maintenance related to ongoing performance monitoring and rebalancing the portfolio as needed.
Best practices require semi-annual reports to investors, typically in the second and fourth quarters of the fiscal year.
Good investment reports include:
- Clear financial information
- Performance data
- Information about developments in the FoF’s underlying investments
These reports should offer investors everything they need to understand how the FoF has performed and pursued its investment strategies over time.
Conclusion
In short, FoFs allows multiple investors to pool their resources and invest in a variety of hedge funds, mutual funds, private equity funds, etc.
While FoF investments are more diversified and therefore more stable, their complexity can cloud transparency, and the double layer of fees can sometimes eat away at returns and lower overall gains.
If you’re looking to start your own fund of funds, consider connecting with us here at Fund Launch.
To learn more about our past successes and how we can help get you started, book a call today!
