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An investor who is intending to invest in a particular asset class such as shares, fixed interest securities or property can choose to invest in a fund of funds. This ensures a more diverse range of investments than an individual investor would be able to contemplate normally because the choice of investments and management of the fund is done by a third party fund manager. An investor seeking even more diversification may choose to invest in a fund of funds which is a collection of investments in mutual funds or other collective investment vehicles.
This investment vehicle will have a manager who chooses which particular funds to invest in. Each will have a particular strategy such as investment in shares of companies operating in emerging markets. The manager will choose to invest in funds which invest in the desired asset class. The choice of investments will be based on the assessment of the performance of each fund and the assessment of the manager who is selecting and managing its investments.
One important point to note is that investing in this type of investment vehicle would involve fees at two levels, firstly the fees charged by the vehicles in which investments are made and secondly the fees of the fund of funds itself. This generally has the result that fees charged may be rather higher than those of an individual mutual fund. The investor must therefore balance this against the advantages offered by investing in this way.
These advantages include the greater diversity of investments and the wider portfolio that can be obtained by the individual investor. It is often considered that a wider investment portfolio leads to greater stability of the investment because the fluctuations that arise from time to time in the value of individual assets are evened out by the spread of the investments. On the other hand although the growth of the investment may be more stable it is also likely to be at a rather lower rate than for a riskier investment in an individual stock or investment vehicle.
It should be noted that the degree of diversity may not compensate well for fluctuations where the investment vehicles in which the manager invests are all specializing in a certain asset class. For example even if the investment contains shares from a wide geographical area it is quite possible for most of those investments to lose value during an economic downturn. Greater stability may be gained where the investment vehicle covers various asset classes such as fixed interest, equity shares and property. In the final analysis no investment however diverse can guarantee that the investor will not lose money.
Use of these investment vehicles may give an individual investor a chance to participate in types of investment that are not normally possible owing to high thresholds for investment. By this means it may be possible for individual investors to participate in hedge funds. These tend to be very risky investments that hold portfolios of high risk assets that differ depending on the particular strategy employed. For example, one strategy might be to invest in distressed securities or in high risk emerging market stocks. By obtaining an investment in a fund of funds covering a wide range of hedge funds and strategies the investor may gain access to the benefits of hedge fund investment while reducing risk through diversification. The manager may also invest in other types of investment vehicle so the investor has a combination of these and other investments.
This type of investment vehicle may also enable investment by ordinary investors in private equity investments. These vehicles are formed to participate in young or growing businesses and carry high risk because they often borrow large amounts to finance their participation. This type of investment is too risky for most small investors but by diversifying the risk the ordinary investor may be in a position to invest in these types of vehicle.
Investors who are calculating the benefit of investing in a fund of funds must realize that it is still necessary to do some homework and decide which vehicle is the most suitable. Each investor has individual aims, specific investment strategies and a timescale for those investments. It is necessary to find the investment vehicle that suits the individual strategy and ensure that the asset class covered by the relevant investment is one that has growth prospects in the medium to long term. An investor would normally be looking to hold the investment for a number of years so that the full benefit of the growth in the underlying investments can be obtained.
