If you’ve been investing long enough, you’ve probably heard about the investment vehicle known as a “fund of funds.” But how these products work and whether you should invest your hard earned cash in them isn’t always a simple question to answer.
As most folks know by now, exchange-traded funds have brought about a revolution in low-cost investing, allowing investors with only a modest nest egg to access strategies that were once characterized by high fees and exclusive access. As a result, ETFs boast some $9 trillion in assets — and with more than 7,000 total products listed worldwide, finding the perfect fund for you in that sea of exchange-traded funds can be a daunting task.
In some ways, fund of funds investing is deceptively simple. As with any other form of investing, you have to have a good sense of your personal goals and risk tolerance, and you have to make sure to research and verify anything before buying. Here are some important things to consider as you look into the fund of funds universe.
What Is a Fund of Funds?
There are ETFs of all shapes and sizes available in 2021, and this variety allows regular Americans to bet on specific sectors, geographies or asset classes with ease. However, that sheer number of funds has also caused a lot of confusion because it’s hard to decide what’s right for you. And sometimes, even this exhaustive list of funds may not provide a perfect fit.
That’s where fund of funds investments come in. A fund of funds investment, sometimes called a multi-manager investment by those in the business, is exactly what it sounds like — a fund that is comprised of other funds. These holdings are what make up the portfolio in lieu of investing directly in individual stocks, bonds or other assets.
A prime example comes from ETF giant iShares via its iShares Morningstar Multi-Asset Income Index Fund (ticker: IYLD), a $250 million fund of funds that seeks a portfolio with an asset allocation of 60% bonds, 20% stocks and 20% alternative assets with an aim of producing a diversified stream of income. Its holdings include 12 other funds which are individually focused on Treasury bonds, dividend stocks, real estate investments and the like to give you that broad mix. And you get all that for a net expense ratio of 0.60%, or just $60 per year on every $10,000 invested.
If you’re an income-oriented investor, chances are you want to cover all these areas. Just as putting all your money into one single corporate bond or dividend stock is incredibly risky, relying on just one single asset class also comes with risks. A fund of funds is a simple and cost-effective way to cover all your bases in a single position to cut down on complexity and confusion in a crowded ETF environment.
Building Your Own Mix
Of course, under U.S. Securities and Exchange Commission regulations, all ETFs — including fund of funds — must report their holdings publicly. So why not simply look up the IYLD portfolio and replicate it on your own without paying iShares a dime?
That’s a fair question. In fact, do-it-yourself portfolio management has a lot of potential benefits including the ability to tweak the allocations slightly based on your personal tastes. Perhaps the most obvious example is that IYLD has stuck only with iShares funds, but building your own unfettered mix allows you to choose from the entire universe of fund providers.
You can also sometimes save on costs because some fund of funds effectively double charge you by layering on a management fee on top of the existing management fees for the underlying funds.
However, managing your own money requires a lot more hands-on attention. For instance, as certain assets rise and fall you will have to “rebalance” your holdings to ensure no single position gets too far out of line with your target allocations. You’ll also have to deal with the risks of hand-picking an inferior fund that doesn’t do what you expect it to, or the risk of managing when to enter and exit these individual positions if and when unexpected news breaks.
For some investors, the cost of a fund of funds is well worth the peace of mind they get. And just like many of us pay someone to mow our lawn or do our dry cleaning, some Americans simply don’t want to be hassled and think it’s money well spent to hire someone else for the nitty-gritty of regular portfolio management.
Pros and Cons of Fund of Funds Investing
As you can see, fund of funds are neither good nor bad. They are simply one more tool in the toolbox of individual investors that may be appropriate in some cases but not in others.
If you’re interested in fund of funds investing, you should start by asking yourself what strategy you’re trying to deploy. Then, after doing your research, you should consider all the available options out there based on factors including:
— Annual fees: Is the diversification worth the costs?
— Performance: Has the fund of funds delivered satisfactory returns in the past?
— Maturity: When did the fund debut, and is it “liquid” with active trading volume and more than $100 million in assets under management?
— Strategy: Is this the best way — or the only way — to achieve your desired strategy, or are there alternatives that seem better based on the prior criteria?
As with so many things on Wall Street, it’s “buyer beware” when it comes to fund of funds. It is crucial to have a clear understanding of your goals and to research any product before investing. However, fund of funds can indeed be a useful tool for certain investors looking to deploy a diversified and hands-off strategy.
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