To understand private equity investing, it’s important to get familiar with the most common transactions that fall under this umbrella. One term new investors may hear is “fund of funds,” or FOF, which is sometimes called a multi-manager investment. In short, an FOF represents a pooled investment fund that in turn invests in other types of funds. The primary fund’s portfolio consists of various underlying portfolios managed by other funds rather than any direct investments in bonds, stocks, and other securities. An FOF can sometimes invest only in funds overseen by the primary fund’s managing company, which means it is fettered. An unfettered FOF can invest freely in all funds.

The main goal of an FOF is to achieve broad diversification and appropriate asset allocations with investments in several different categories in a simple, efficient, and manageable way. Different types of FOFs exist, and only a portion of them represent private equity investments. FOFs can also be structured as mutual funds or investment trusts. Investors should make sure they understand the scope of investments undertaken by the fund before they consider this option. Since FOFs can invest widely, investors may be caught off guard by how their investment is allocated if they do not pay close attention and do substantial due dilligence on the front end.

Understanding the Advantages of a Fund of Funds

The FOF structure has a number of advantages, particularly for smaller investors who want greater exposure without the risks involved in direct investing in securities or even individual funds. Especially with private equity FOFs, accessing the investments can involve significantly less upfront capital than would be required with direct investments. The average investor generally cannot access the underlying assets in FOFs, so it is a great way to get started with a class that can be quite exclusive for smaller investors. Individual funds may require a minimum investment of seven figures or demand that individual investors have a minimum net worth, but these rules do not necessarily apply to the FOFs investing in them.

The other major advantage of an FOF is the immediate access to diversification, which potentially reduces the risk of the investment. Furthermore, this structure means that investors benefit from the considerable expertise of industry experts. The majority of FOFs require a formal due diligence procedure for their fund managers, as well as those overseeing the underlying funds. These background checks and credential verifications ensure that managers have the proper experience and background to manage the assets. Investors can benefit from this expertise without having to make their own decisions as they would if they were making direct investments. When it comes to private equity investments, this access to deep knowledge can be invaluable.

Breaking Down the Disadvantages of a Fund of Funds

While the advantages of an FOF are attractive, investors also need to understand its limitations and challenges. The primary issue that many investors have with FOFs is investment fees, which can be considerably higher than those associated with more traditional investment funds. With an FOF, fees are compounded on top of other fees. In other words, the FOF passes the fees of underlying funds along to its investors and adds its own fees on top. So while returns can be impressive given the greater diversification and limited exposure to market volatility, the fees can significantly reduce actual returns. Even when the FOF performs very well, the returns can be lower than those of single-manager funds that did not perform as well.

An FOF will usually charge an annual operating expense in addition to management fees and operating costs. The issue is that the underlying assets also levy the same charges, so investors end up covering many more fees than they would with direct investments. Not long ago, the fees imposed by FOFs on investors were often opaque and unclear. The FOF prospectus was not required to include the fees of underlying funds until January 2007. However, the SEC now requires that these fees be disclosed in a specific section titled “Acquired Fund Fees and Expenses.” This shift eliminated much of the uncertainty involved with investment in FOFs.

Another limitation of FOFs that investors should keep in mind is the difficulty in securing great fund managers. This problem is especially true for fettered FOFs. When the structure is fettered, the FOF often ends up owning the same stock or security through several different funds, which reduces the actual diversification. This problem is concerning for investors on its own, but it also discourages great fund managers from taking the reins, since they know the limitations.

Investigating the Average Return of Funds of Funds

Doing due diligence for an FOF can be difficult. The structures can vary considerably, so direct comparison can be nearly impossible. However, investors can rely on the Barclay Fund of Funds Index. This tool reports the average return of various FOFs in its database. Currently, the database includes around 800 FOFs, so it is an important resource. Investors should check to see if a particular FOF they’re interested in is represented in the index. As of March 2019, the entire database had an average return of 3.95 percent.