Buying a mutual fund is a bit like hiring someone to fix the brakes on your car. Sure, you could do the research, buy the tools and fix the car yourself (and many people do), but often it's not only easier but also safer to let an expert handle the problem. Mechanics and mutual funds may cost you a little more in fees, but there is nothing inherently wrong with paying extra for peace of mind.

Some investors prefer even more peace of mind. By purchasing a mutual fund that invests in other mutual funds, they get the added protection of multiple money managers and much more diversity than one fund would give them. A fund of funds (FOF) is an investment product made up of various mutual funds—basically, a mutual fund for mutual funds. They are often used by investors who have smaller investable assets, limited ability to diversify or who are not that experienced in choosing mutual funds. In short, an FOF gives the little guy the professional management and diversification that have often been reserved for the wealthy. In this article, we will explore the advantages, disadvantages and risks of an FOF.

Benefits of a Fund of Funds

An FOF spreads out risk. Whereas owning one mutual fund reduces risk by owning several stocks, an FOF spreads risk among hundreds or even thousands of stocks contained in the mutual funds it invests in. FOFs also provide the opportunity to reduce the risk of investing with a single fund manager.

Because each mutual fund has a minimum investment threshold to buy in—usually $1,000—the individual may not be able to afford to meet the minimums for several mutual funds at once. Buying a mutual fund that invests in other funds means the individual does not have to meet that minimum.

The emergence of FOFs is being pushed by demand from investors to have more safety while trying to keep up with or beat the market. However, it must be said that the benefit of more safety is not endless. If the overall market takes a tumble, so may mutual funds and the FOFs that have invested in them.

Fees and Expenses

An investor who purchases an FOF must pay two levels of fees. Just like an individual fund, an FOF may charge management fees and a performance fee, although the performance fees are typically lower than individual mutual funds to reflect the fact that most of the management is delegated to the sub-funds themselves.

FOF Advantages

An FOF serves as an investor's proxy, providing professional due diligence, manager selection, and oversight over the mutual funds in its portfolio. The professional management provided by an FOF can give investors the ability to spread their dollars among thousands of stocks with a single purchase, while counting on expertise that investors themselves may not have. Rather than assuming the risk of selecting one individual manager, the FOF provides a portfolio of managers with a single investment.

Most FOFs have a formal due-diligence process and will conduct background checks before selecting new managers. In addition to searching for a disciplinary history within the securities industry, this work can include researching the backgrounds, verifying the credentials and checking the references provided by a fund manager of any individual fund that is being considered as an investment. 

FOF Disadvantages

Overall, fees for FOFs are typically higher than those of individual funds because they include both the management fees charged by the FOF and those of the underlying funds. This doubling up of fees can be a significant drag on the overall return an investor receives.

Since an FOF buys many funds (which themselves invest in a number of securities), the FOF may end up owning the same stock or other security through several different funds, thus reducing the potential diversification.

The Bottom Line

FOFs can be a pain-free entrance into professional diversification for investors with limited funds, or for those who have limited experience, but this doesn't mean every FOF will be the perfect fit. An investor should read the fund's marketing and related materials prior to investing so that the level of risk involved in the fund's investment strategies is understood. The risks taken should be commensurate with your personal investing goals, time horizons and risk tolerance. As is true with any investment, the higher the potential returns, the higher the risks.

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