What is a Fund of Funds?

A brief overview of the nature of Fund of Funds in 2021

• January 2021

Something distinct from direct investments in individual stocks, shares, bonds, and the vast catalogue of securities and assorted vehicles, a Fund of Funds (FoF) is a fund, managed, as usual, by a fund manager or investment firm. However, FoF only invest in those portfolios that consist solely of other hedge funds, mutual funds or private equity funds. Having said that, there does exist a relatively wide variety of FoF all with their own identity and different risk profiles, with commitment periods usually ranging from three to five years, from asset allocation funds and exchange traded funds through to Multi-Manager and a FoF that acts as an investment trust.

Through a particularly focused investment strategy, FoFs generally achieve high levels of diversification, culminating in solid reductions in risk and volatility which in turn increase exposure. This is especially helpful for those investors with budgets that would otherwise be short of the minimum investment for hedge fund entry, as a pose to a FoF made up of numerous hedge funds, which is far more financially accessible. Funds such as Lindell train’s UK Equity Fund, Aberdeen Standard’s Multi-Manager Cautious Fund and Allianz’s Strategic Bond Fund have remained popular choices with UK fund managers for reasons such as these. Furthermore, the high levels of diversification exhibited by FoF can serve in bringing balance to the value bias of other funds held within the same portfolio.

Frequently tracked via the Barclay Fund of Funds Index where between 300 and 600 fund of funds regular send performance reports, fund of funds investments generally have higher expense ratios than most mutual funds as the underlying funds that make up an FoF often if not always have their own fees, as well as the operating cost and management fee of the FoF itself that must be paid, all of which makes FoFs on the whole less profitable than other fund types. They are however still often considered to be excellent value due to their well documented and considerably broad diversification, especially for smaller investors with less appetite for risk. This fact also means smaller investors can gain exposure to the best money managers on the market, managers who would remain out of the financial reach of these smaller investors if it were not for the pooled investment approach of FoF.

Following on from this, it is somewhat ironic that some FoFs can become so effectively diversified that it becomes impossible for them to outperform the market. Then again, conversely, FoFs can end up holding the identical stocks, securities or other specific investment products through investing in different funds that may have a similar underlying theme, investment strategy or desired investment outcome, which would act by reducing diversification levels in a portfolio exhibiting this type of investment overlap.

Fund of Funds selection & management with Alternativesoft

In October 2020 The US Securities & Exchange updated the Regulatory Framework for FoF arrangements due to their ongoing popularity and in order to “provide flexibility to fund managers to allocate and structure investments efficiently, without the costs and delays of seeking individualized exemptive orders, as long as the arrangements satisfy a number of conditions designed to enhance investor protection”. This new framework is mooted to make FoF investments more popular and more appealing.

Fund of funds investments in 2020 were somewhat of a mixed bag as much of the developed world began to slowly adapt to the idea of the new reality of the ongoing global pandemic. In terms of cumulative returns from Jan 2020 to Nov 2020, an equally weighted portfolio of the five largest mutual funds by AUM outperformed the world market index (50% ETF MSCI, 50% BB Barclays), whereas an equally weighted portfolio of the five largest hedge funds by AUM underperformed the world market index.

These observations about the five largest mutual and hedge funds above is a useful illustration of why it is currently of even greater importance to have a detailed and methodical approach to fund of funds analysis, selection and management, as well as an effective digital platform with the appropriate quantitative analysis techniques to make it all happen quickly and coherently.

Alternativesoft’s investment software platform is not only used by investment professionals across the globe, but it has been the platform of choice for some of the largest and most successful multinational investment institutions for a number of years. Equipped with a comprehensive set of quantitative tools that facilitates the of simple or complex sets of statistical and peer group analysis, subsequent highly detailed customisable reports, the platform also features compliance and auditing solutions keeping all the key processes for fund management at your fingertips.

The steps to selecting and maintaining active management of the right FoFs with the desired level of risk exposure most conducive to reaching that specified investment goal has never been a more informed or detailed process than now with Alternativesoft. Our dedicated and enthusiastic team passionately live the life of financial investment theory and practice, further making sure to staying informed with the latest developments in the relevant computer science in order to not only provide maximum support to clients, but to maintain a relentless schedule of regular updates to the software platform so our clients can stay ahead of the curve.