Considerations
Management fees for Funds Of Funds are typically higher than those on traditional investment funds because they include the management fees charged by the underlying funds. As in the case of schemes of mutual funds, FOF schemes also work under the due diligence of a fund manager. This gives the scheme an additional expertise. It also helps to provide access to information which may be difficult to obtain information by an investor on a case by case basis. Every fund manager has a particular style of diversification. This diversification has a perfect correlation with the number of managers involved. Once a FOF reached a certain level of managers, adding more flattens return curve and diversifies away alpha (Harry Prasun Kat2). Since a fund of funds buys many different funds which themselves invest in many different securities, it is possible for the fund of funds to own the same stock through several different funds and it can be difficult to keep track of the overall holdings.
Funds of funds are often used when investing in hedge funds and private equity funds, as they typically have a high minimum investment level compared to traditional investment funds which precludes many from investing directly. In addition hedge fund and private equity investing is more complicated and higher risk than traditional collective investments. The lack of accessibility favors a FoF with a professional manager and built-in spread of risk.
Pension funds and other institutions often invest in funds of hedge funds for part or all of their "alternative asset" programs, i.e. investments other than traditional stock and bond holdings.
After allocation of the two levels of fees payable and taxation, returns on FoF investments will generally be lower than single-manager funds.
The due diligence and safety of investing in FoFs has come under question as a result of the Bernie Madoff scandal, where many FoFs put substantial investments into the scheme. It became clear that a motivation for this was the lack of fees by Madoff which gave the illusion that the FoF was performing well. The due diligence of the FoFs apparently did not include asking why Madoff was not making this charge for his services. 2008 and 2009 saw fund of funds take a battering from investors and the media on all fronts from the hollow promises made by over-eager marketers to the strength (or lack) of their due diligence processes to those carefully explained and eminently justifiable extra layers of fees, all reaching their zenith with the Bernie Madoff fiasco.
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