What is a Fund of Funds

A fund of funds is a type of mutual fund that is made up of other mutual funds (and occasionally ETF’s).  Similar to a book that is a collection of poems.  You get a bunch of different poems in one book.

Why Fund of Funds Exist

These funds were designed to make investing easier by placing all of your allocations in one fund.  Hypothetically you could have only one fund, instead of multiple funds.  You put your money in and the managers take care of the rest.

Types of Fund of Funds

There are three main types of fund of funds:

  • Asset Allocation – These funds aim to provide you with some level of asset allocation, while at the same time trying to ride the market to grow your money.  Because of trying to mix these two things allocation funds end up with a wide range of investing guidelines.  The managers tend to have a lot of freedom in their investment decisions.  A Growth oriented allocation fund might allow anywhere from 35 – 90% equity allocation depending on what the manager thinks will happen in the market place.  Many allocation funds are labeled as defensive, moderate, growth or aggressive funds.  This way you can select your level of risk that you want to take.
  • Balanced Funds – A balanced fund’s goal is to keep an allocation of roughly 40% bonds and 60% stocks.  They focus on balancing safety, income and appreciation.   Typically they do not vary their position as much as an asset allocation fund as they are not trying to time the market.
  • Life Cycle Funds (Target Date) – These funds align your allocation to a specific year that you want to use the money and adjust as you get closer to that time.  These are mainly used for retirement and college education. (Click on the link to get detailed information on these types of funds).

If you are in doubt if a fund is a balanced fund or an asset allocation fund, you should read the prospectus to understand what extremes the managers are allowed to go.  All funds are required to have specific limits and guidelines on where they are investing.  You will see exactly what the minimum and maximum percentages are in each asset category.

The Benefits of a Fund of Funds

  • If you are using a balanced fund or a life cycle fund then you don’t need to worry about your allocation being off.
  • If you are using an asset allocation fund you don’t have to worry about being in the right place at the right time.
  • When you are just starting out with investing it does allow you to get adequate allocations with smaller amounts of money, especially with the balanced and life cycle funds.

Negatives of a Fund of Funds

  • May not match your risk preference – the fund may end up taking on much more risk than you would normally consider taking in an investment (or possibly less risk).  Especially with asset allocation funds.
  • Expenses can be high – fees can kill your investment return.  So it does not help that with the fund of funds two sets of fees come into play.  The first is the expense ratio for the fund itself.  The second is the expense ratio for the underlying funds.  Because of this, you may be paying way more in fees than is healthy for your portfolio.
  • Only as good as the investment company – most fund of funds use funds from their own company to create your portfolio.  Thus if you use the Vanguard fund then it will contain Vanguard funds, likewise Fidelity will use Fidelity funds.  This means that your investments are only as good as the company.  You need to ensure the family of funds has a strong history of good performance.  This becomes harder to track for companies such as State Farm, which hires out a firm to manage for them, at this time it is BlackRock but this can change at any time if State Farm decides to hire a new manager.
  • If you are using an allocation fund you will have to move your investment as you get closer to retirement to make sure you are taking on the right amount of risk.  It is not a “permanent” fix like a life cycle fund.

How to Determine if a Fund of Fund is Right for You

Look at the Current Allocation

First you want to make sure that the level of risk that the fund is taking is what you find acceptable.  (Not sure what your asset allocation should be?  Here is my favorite chart to help you decide.) To do this you can do this one of two ways:

  1. Go to the fund companies website, find the fund and within their information you should find the current assets.  For example at Vanguard if you go to the investor site and then key in the ticker symbol you can find a summary of information with a tab for the Portfolio.
  2. Go to Morningstar.com and at the top of the page key in ticker symbol in the quote box.  Then click on the portfolio tab.

Remember, even if the guidelines are in line for everything that is recommended if you are uncomfortable with the investments then you should not invest in them.  You still need to sleep at night.  You can build a more conservative portfolio using individual funds.  Just remember you may need to save more to get to where you want to be by taking less risk.

Look at the Expenses

This step you can continue to use one of the two resources from the above section.  You will want to look up not only the funds cost, but also the cost on the underlying funds.

On the funds website the information on the cost of the fund should be on the summary page.  Then to get the cost of the underlying funds you need to head to the portfolio information and take a look at each of those funds.  Once you have those you can search for each of those funds on the site and go to its summary page to get the expense ratio.

On Morningstar it is a bit easier, on the portfolio page at the top click on Holdings and then scroll to the bottom.  Here you will see a list of funds, you can actually click on the fund and it will open a new tab for that fund, from here you can click on quote and see the fees!

While determining the exact amount of fees that is acceptable can be difficult, I would recommend you try and stay under 1.25% and preferably under 1%. I did write a post on fees if you need more information.  The Impact of Fees on Mutual Funds

Check the Management Company

This is probably the hardest thing to measure, as many fund companies have fantastic funds and also some bad funds.

Other than going fund by fund, I recommend heading to Morningstar and using their Fund Family pages.  Now, these are not overly easy to find, but head to the bottom of the page, select the Site map and then under Mutual Fund Performance data you can select the fund company you are looking at.  Once you click on that fund you can do a quick scan of the fund companies funds, rating and returns. If you click on the words Data Pages next to the name, it will take you to a snap shot page that includes averages for expenses, returns and lots of great information.

By scanning this information you should be able to determine if across the board fees are reasonable and how many funds are on the bad side that you may be invested into.

Are you going to reallocate?

Finally assuming that the risk levels are acceptable, the fees are good and you are happy with the fund company.  You need to decide if you would rather set it and forget it with a fund of funds, or if you would once a year rebalance your portfolio and adjust your allocations they vary and the market changes.  If you can pretty much guarantee that you won’t touch it after you set it then one of the fund of funds is probably the best way for you to go.  If you will sit down once a year and make sure you are on track, then you may be better off picking individual funds as you will pay less in fees and you have more control over what you are invested in.

Ultimately it is a decision that can only be made by you.  You need to look at all the information, pair that with your personality and habits to create a winning investment plan for you.  Happy Investing!

1 comment
Tom@easyfinance says May 11, 2012

Brilliant post indeed. Fund of funds is basically an investment strategy of holding a valise of other varieties of investment funds rather than investing directly in shares, bonds etc.Its sort of a multi-manager investment. A fund of funds can be invested both in funds managed by the same investment company, or even it can invest in external funds as well. Now a days through websites we can have a vast expanse of idea to make a right choice.The article is definitely a major source of knowledge provider.

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