What is Fund of Funds (FOF)?
A Fund of Funds (FOF) refers to a pooled investment vehicle in which capital commitments from investors are allocated to a predetermined number of funds with different strategies.
Fund of Funds (FOF): Investment Strategy
The value proposition of a fund of funds (FOF) to its investors is the ability to take over the responsibility of strategic asset allocation.
Conceptually, the fund of funds investment strategy can be thought of as a “portfolio” comprised of multiple different funds.
Most often, fund of funds managers invest in the following firms:
- Private Equity Firms
- Hedge Funds
- Mutual Funds
Since the fund of funds is an investor in these actively managed funds – i.e. the FOF is a limited partner (LP) – the fund structure is often referred to as a “multi-manager investment fund.”
Therefore, rather than selecting individual stocks and bonds to invest in, or participating in riskier strategies like early-stage venture investing, growth equity, or late-stage buyouts – a fund of funds (FOF) performs diligence on active managers to invest.
The majority of the diligence conducted by a fund of funds (FOF) focuses on the following areas:
- Fund Selection (Manager)
- Asset Class Allocation
- Sectors and Industry Trends
- Portfolio Weighting
The value-add of these firms is identifying the right funds to allocate capital in order to maximize returns while simultaneously managing the downside risk by spreading their capital across different firms, fund strategies, sectors, and asset classes.
Fund of Funds (FOF): Benefits to Investors
The value proposition to investors is the benefit of diversification, i.e. the risk of the portfolio itself is reduced by holding investments across a broad set of asset classes and/or investment strategies.
Since a fund of funds (FOF) invests in active managers, the limited partners (LPs) of a fund of funds receive indirect exposure to not only one (or two) but numerous active managers.
The next benefit is the lower minimum qualification requirements to be a limited partner (LP), making FOFs more accessible to a broader range of investors.
In particular, top-performing funds will often decline LP inquiries that are too small in investment size because of the sheer abundance of demand, so a FOF (and their pooled capital) can be one method to bypass the minimum threshold to “get in on” the fund.
In effect, individual investors and smaller-sized institutional investors that might not meet the criteria to be an LP in certain funds can be effectively “grouped together” via the FOF to gain access.
The performance information of managers – especially for private equity and hedge funds – lacks transparency, as the data is typically considered non-public confidential information, barring some exceptions.
