A Mutual Fund May be a Fund of Funds

When people invest in stock mutual funds, they assume the investment manager is researching, evaluating and purchasing the common stocks of various companies to be included in the fund. This is normally true. The investment staffs of most large mutual fund companies include research analysts who specialize in the various industries, such as the Auto industry, Financial industry, etc. These professionals understand their particular industry and recommend the best stocks to be purchased. These potential stocks are then reviewed by the fund’s investment team for possible purchase by the fund.

What is a Fund of Funds?

A Fund of Funds is simply a mutual fund that invests all or a portion of its assets in other funds. If an investment manager of a mutual fund has this power, it would be stated in the fund prospectus. An investor may have purchased a Fund of Funds without even knowing it. This does not mean there is problem or danger. It does mean that the investor should understand where the assets are invested, and why the investment manager is purchasing other mutual funds.

Why would a Mutual Fund Manager Buy Other Funds?

There are several reasons why a mutual fund investment manager would want to buy other mutual funds.

  • Combine Different Investment Styles and Objectives – some mutual funds are constructed to provide total investment diversification across asset classes, sectors and company size. These funds attempt to relieve the investor of having to make most investment decisions. For example, a balanced mutual fund will invest in both stocks and bonds for complete diversification. If the manager is a specialist in equity, he may not have the experience or inclination to also buy individual bonds. Therefore, such a manager can use a portion of the assets to buy into a bond fund, and spend most of his time focusing on the stock portion of the fund. Essentially, this manager achieves his investment objectives in bonds by making only one or two purchases.
  • Simple Method of Purchasing Core Fund Holdings – There are times when a mutual fund investment manager may want to invest in a basket of stocks to match an investment index. For instance, the manager of mutual fund may have the investment objective of investing in large companies, diversified across all industries and a blend of Value and Growth stocks. A core portion of such a portfolio may be all companies in the S&P 500 index. Such a manager could buy all 500 stocks within the index. However, there are so many index funds which match the investment returns of the S&P 500, it is simpler for the manager to invest in one of those funds. Why duplicate desired holdings that already exist in other funds.

Beware of Fund of Fund Expenses

While it would appear easier or more efficient for mutual fund managers to invest in other mutual funds, the investor needs to understand the effect of expenses. All mutual funds charge expenses. If one mutual fund invests its assets in other mutual funds, there are duplicate expenses being charged to shareholders. For example, Mutual Fund A charges annual expenses of 1% of assets, and Mutual Fund B charges 2% of assets. Should Mutual Fund A invest half its assets in Mutual Fund B, the shareholders of Mutual Fund A would experience expense charges of 1.5% on all assets.

As a general rule, Fund of Funds expenses are higher than mutual funds that consist of all individual stocks. However, Funds of Funds most times have better diversification. The investor needs review all fund holdings to see how many mutual funds are being held and why they are being held.

Learn from the Prospectus and Forums

There is normally no issue if an investor discovers that his mutual fund is a Fund of Funds. Such investors can be comfortable with the fund as long as the investment manager is using other mutual funds for efficiency and diversification. Should an investor find that the manager is investing in more risky mutual funds or specialty funds, such investor needs to do more research as to why the investment manager is doing this compared to the overall investment objective of the fund.

Investors should scour the fund prospectus and participate in several investment forums to ascertain what is actually occurring in the fund. If not completely comfortable with his findings, the investor should look elsewhere to invest his assets.