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Fund of Funds Explained

A fund of funds is a collection of mutual funds bundled together. By combining different mutual funds into one package, the fund of funds purpose is to give you a single-choice investment solution. You’ll sometimes see a fund of funds abbreviated as FOF.

This can simplify your investment process, but you need to understand how a fund of funds works. There are some advantages as well as disadvantages to investing in a fund of funds. I’ll explain some of them here. You can use these points to determine if a fund of funds is right for you. If you do think a FOF is the right choice this discussion can also help you select the one that fits you best.

A Fund of Funds Offers Simplicity

Everyone invests differently depending on the goals they want to achieve. When you invest your money, you need to be sure that you are investing in a way that targets your own goals. These objectives can range from aggressive growth to capital preservation or even income for retirees.

At a high level, this means deciding how to divide your money between different types of investments. You’re probably familiar with this already. We call this step in the investment process asset allocation.

Next, you’ll need to decide the specific stocks, bonds, or funds to include in your portfolio.

Typically, you’ll either work through these decisions yourself or have a financial planner help you. A fund of funds can help you with this as well. You might look at these as an option for someone who doesn’t want to do it completely on their own, but doesn’t necessarily need or want professional help either.

These funds have stated investment objectives just like any other mutual fund or ETF. You can simplify the second step by selecting a fund of funds with a stated investment objective that mirrors your own. The fund then invests your money in different mutual funds that the fund manager believes will accomplish those objectives. It does this by splitting your invested dollars out among all the different funds that make up the fund of funds.

For example, your FOF may hold a fund that covers the S&P 500 index, a different fund that invests in high-quality corporate bonds, another fund that invests in emerging markets, and then a short-term government bond fund. Instead of you selecting each of these funds individually and deciding how much money to invest in each one, the FOF manager does for you. You would hold each fund by virtue of the fact you hold the top-level fund that contains each of them.

Diversification

A fund of funds gives you instant diversification. Because the fund holds underlying funds, it will automatically divide your money up among all those funds. Again, you could diversify yourself by selecting a variety of individual investments, but it’s done automatically with a fund of funds.

There is potential for overlap in a FOF. The underlying funds could hold some of the same stocks or bonds. This is also a risk when you select funds yourself too. Just keep this in mind if you are selecting a FOF and try to limit it as much as possible. The harm here doesn’t come directly from the fact that you hold two funds that invest in the same stocks. The harm is in the indirect effect of not having as much diversification. It would be better if the funds have minimal overlap.

The diversification benefit of a FOF is especially useful for small accounts. An investor with a small account may not be able to achieve good diversification by investing in the individual funds directly because of minimum investment amounts.

Portfolio Re-balancing

Since the fund of funds has an overall objective to maintain, it will keep any money invested in a way that would be expected to accomplish that objective.

A FOF that with a target allocation of 80% stock and 20% bonds will get off those targets when the markets move. That’s no different than your own portfolio. This means the fund will have to periodically re-balance the underlying mutual funds. Because the fund of funds re-balances its holdings, you don’t have to worry about that ongoing piece of portfolio management.

You do, however, need to make sure that the fund you are using doesn’t drift. While the fund will re-balance the underlying funds periodically, the fund management could also decide that the allocation needs to change. If that happens, you need to make sure that the allocation is still one that you agree is best for you.

Fund management could also decide to remove one of the underlying funds and replace it with another. It’s likely that they do this because they believe the new funds is a better fit, but you’ll still need to monitor this as well.

If you are prone to give less attention to the not-so-exciting parts of managing your investments, or ignore them altogether, this re-balancing could be especially beneficial to you.

Fund of Funds Expenses

One drawback to using a funding of funds is the expense. There is an additional layer of management to organize and direct the fund investments. Because of that, there is also an additional expense layer.

You can see the fund of funds expenses by looking at the expense ratio. The expense ratio is expressed as a percentage of the money you have invested in the fund. If the fund has an expense ratio of 1%, then 1% of your money is used to cover the expenses associated with running the fund each year.

Here’s the sticky part though…

Each of the underlying funds have their own expense ratio. Does the fund of funds expense ratio include those expenses as well? Yes! If you don’t understand what I mean by that, here’s a simple breakdown. Suppose your fund combines two mutual funds. Fund A has an expense ratio of .50% and Fund B’s expense ratio is .50% as well. (I kept them the same to simplify this illustration.)

If your fund of funds expense ratio is 1%, is that inclusive of the .50% in underlying fund expenses for a total of 1%? Or, is that 1% plus the .50% on the underlying funds for a total of 1.50%?

It used to be the case that the top-level expense ratio did not ave to include the underlying expense ratios. In that case, the published expense ratio could be a little misleading. You need to not only include the FOF expense ratio, but the weighted average of the underlying funds expense ratios as well.

As of 2007, FOFs must report the fees of underlying funds as Acquired Fund Fees and Expenses (see page 20 of this document). That’s a win for fee transparency.

FOF Fee Example

For an example of a fund of funds fee let’s look at the iShares Core Growth Allocation ETF from Blackrock. As of the time I’m writing this article it holds a number of other iShare ETFs to include the total US bond market, S&P 500, international bond, emerging markets, and a few others. It reports a net expense ratio of .25%. Here are the reported fund fees:

Expense Ratio.32%
Management Fee.25%
Acquired Fund Fees and Expenses.07%
Foreign Taxes and other Expenses0%
-Fee Waivers.07%
Net Expense Ratio.25%

In the Fees and Expenses Breakdown we see that the acquired fund fees and expenses are .07%. That’s basically a weighted average fee for all of the underlying funds. However, you can also see that there is an item waiving those fees. In effect, you are paying .25% for both the underlying funds and to have Blackrock management them for you.

Notice here that Blackrock manages the FOF, and builds it with other Blackrock funds (iShares ETFs, specifically). It’s typical for a fund family to waive a portion of the fees when they do this. That helps reduce the total fees some.

You could go out and select and balance these funds yourself for an average expense of .07% and save the additional .18%. Whether you do or not is partially a matter of how involved you want to be in managing your own investments. To give you a straightforward metric to decide by, .18% comes out to $180 per year for every $100,000 you have in the fund.

Note that this is only an example to illustrate fund fees and I’m not suggesting you should (or should not) invest in this fund.

FOF Investment Style

Any time you offload investment management to someone else you need to be sure their investment style fits your own. There are FOFs for most investment styles including active strategies and passive index investing. The iShares example above is an example of a passive fund. That’s the main reason the expenses are so low.

Active FOFs will have higher expense ratios.