What is a fund of funds?
Most mutual funds build diversified portfolios of individual stocks, bonds, and other securities. A mutual fund of funds instead invests in other funds.
Usually, a fund of funds is created to implement a particular asset allocation strategy. For instance, target date funds shift assets from stocks toward bonds over time, getting more conservative as shareholders get closer to retirement. These funds can periodically sell many individual stocks and buy many bonds; instead they could just sell shares of one stock fund and buy shares of one bond fund.
Why you should avoid funds of funds
Uncontrolled asset allocation
When you invest in a fund of funds you surrender control of your own asset allocation to another party. Your tolerance for risk should determine the percentages of your portfolio devoted to stocks and bonds. Funds of funds may indicate targets, but in practice they can deviate out of line with your own preference or risk tolerance.
After you put the effort into determining an appropriate asset allocation, you should not introduce doubt during its execution.
Layers of fees
All mutual funds charge fees. Some funds of funds offset fees of the mutual funds they purchase to prevent double billing. Many do not.
Piling on fees impedes performance. Figure 23-1 demonstrates the process. Basically, stocks and bonds generate income and growth. Each level of product that comes between you and those stocks and bonds will detract from your portfolio’s performance.
Fund family bias
Some funds of funds research targeted market segments seeking ‘best in breed’ selections. Many funds of funds utilize products in the same fund family. Instead of finding the best stock and bond funds, these in-house funds of funds are forced to invest in the stock and bond funds managed by related parties regardless of fees or merit.
Reduced transparency
Mutual funds regularly provide portfolio details that include lists of securities. For funds of funds, these lists will include the names of funds, not the stocks and bonds ultimately held. While it is not impossible to get those details, it takes extra work.
What you should do instead
Is your fund of funds a target date fund? Click here for more context and corrective action.
Is your fund of funds risk related, with an emphasis on aggressiveness, conservatism or moderation? Click here for perspective and actionable ideas.
If you own or are considering a fund of funds as a one-stop solution to your investing needs, execute a proper investment regimen instead. Click here to see an example of an easy path to such a regimen.