Ever hear of a turducken? It’s a deboned chicken that is stuffed into a deboned duck, then further stuffed inside a turkey and then roasted into a delicious abomination. A fund of funds is a little like the financial world’s turducken in that it’s an investment vehicle (the first “fund” of the title) that doesn’t buy individual assets, but rather invests in one or more funds that contain assets. The term fund of funds is a super general term since its constituent funds could invest in virtually anything. Though they’re most often associated with hedge funds, university endowments and company pension funds would technically be considered fund of funds, since they often invest in various mutual funds. Those who feel silly saying “funds of funds” may instead refer to them as “multi-manager investments.”
The obvious advantage of investing in fund of funds is diversification. Having your investment divided between four or five hedge funds rather than just tossed into one can provide more consistent returns not to mention peace of mind. The major disadvantage is the fee structure. Fund managers assess fees for their expertise as do fund of funds managers so you end up with a double layer of funds that can dramatically erode any investment gains. Many fund of funds wouldn’t disclose the fees charged by funds they bought so in 2007 the Securities and Exchange Commission added an “Acquired Funds Fees and Expenses” (AFFE) rule that stipulates that fund of funds must disclose not only its own management fees, but the fees of any investments it contains.
Historically, funds of funds have suffered from reputational issues. The first fund of funds (as well as the clunky title) came from a scoundrel named Bernie Cornfeld, who started his FoF in the early sixties, and ended up doing prison time years later for stealing long distance phone service. Then another Bernie—Madoff, this time—further sullied their name when authorities discovered in 2008 that he’d been stealing all the money invested in his company via several feeder funds of funds. It’s a cautionary tale that explains why due diligence, the technical term for the tire kicking of any investment, is one of the core responsibilities of fund of funds managers.