An increasingly complicated investment arena and market volatility have driven demand for "fund-of-funds" investments-funds that invest in other mutual funds, rather than in individual securities.

When you invest in a fund of funds, your money is combined with the money of many other investors. Professional investment managers use this pool of money to create a portfolio of many mutual funds, representing various asset classes and market sectors. The result is a broadly diversified mutual fund portfolio.

Because funds of funds provide a convenient, prediversified investment solution, they may be a good option for your retirement investing, or if you are new to mutual fund investing. Their broad diversification also can make them an appropriate foundation for building a well allocated portfolio, though diversification alone cannot ensure against loss.

Focus on Objectives

Like traditional mutual funds, a fund of funds has a stated investment objective, such as growth or income. These funds are designed to meet specific investment time frames or risk-based needs. They often provide a pre-set mix of various mutual funds, offering you a diversified, automatically rebalanced portfolio within a single investment.

Fund of funds' management structures vary, too, ranging from:

  • Funds of funds that invest exclusively in the issuing firm's own mutual funds;
  • Funds that invest in funds offered by other companies;
  • Funds that offer investors access to institutional funds that normally are not available to individual investors; and
  • Funds that have the ability to invest in load funds (those that carry a sales charge) without paying the load.

Gain the Benefits

Funds of funds can offer a number of advantages, including:

  • Greater Diversification: A traditional mutual fund diversifies across many stocks, bonds or money market securities, while a fund of funds can provide exposure to far more securities. By spreading your investments across a number of funds-whose assets are invested in different asset classes and across market sectors, industries and securities-you may reduce your portfolio's overall volatility.
  • Value: Account minimums, which typically can range from $500 to more than $10,000, might make it difficult to invest in numerous funds. A fund of funds allows investors to diversify among hundreds of stocks, bonds, and money market securities with a single minimum investment.
  • Convenience: A fund of funds provides broad diversification with less paperwork and record keeping. And because its returns reflect that of the underlying funds, it's easy to see how the various fund components are performing during market cycles.
  • Professional Management: Fund-of-funds investments offer professional security selection, portfolio construction and, often, active management. Asset weightings within target-date funds of funds are altered over time, from aggressive to conservative as they approach their target date. This relieves you of the need to move from one fund to another in response to changes in your investment time frames or risk tolerance. Risk-based funds of funds are periodically rebalanced to maintain a pre-set asset allocation and to control risk.

Understanding Fees, Holdings

Expense ratios on some fund of funds may be higher than those charged by regular funds because they include part of the expense fees charged by the underlying funds. Not all fund of funds charge an additional management fee, however, so it's wise to check expense ratios for each fund.

In addition, because a fund of funds invests in many different funds that in turn invest in many different securities, there may be some overlap. If you invest in a technology fund as well as a fund of funds that invests heavily in technology stocks, for example, you may ultimately hold the same stocks in both funds. Be sure to understand your fund of funds' holdings and how they compare with the holdings of other funds in your portfolio.

Evaluate Performance and Risks

A fund of funds' performance depends on that of its underlying funds. The underlying funds are subject to the volatility of the financial markets and, depending on the types of funds in which they invest, may be subject to additional risks associated with investing in specific market sectors or foreign securities. A fund of funds that invests in international funds also may be subject to currency risk and exchange rates. As with any investment, the value of a fund of funds' shares will fluctuate, and the value may fall below the original investment.

By investing in a fund of funds, you receive the benefits of broad diversification and professional investment management in a convenient package. Be sure to read the prospectus carefully before investing or sending money. The prospectus includes details about the fund's objectives, investments, fees and other information. And, remember, diversification does not assure a profit or protect against a loss in a declining market.

Investment return and principal value will fluctuate, and it is possible to lose money by investing.

This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

Diversification does not assure a profit nor does it protect against loss of principal.