Fund of Funds

A fund of funds is a registered fund whose investments are shares of other funds. Instead of a manager selecting securities, the manager selects funds, and the investor's money reaches the underlying stocks and bonds through two vehicles rather than one. The Securities and Exchange Commission's 2020 final rule is captioned "Fund of Funds Arrangements" and defines the subject in its own summary as "funds that invest in other funds".

Two naming points prevent confusion. First, the phrase describes a portfolio construction, not a product category: a target-date fund, a broad asset-allocation fund and an institutional multi-strategy vehicle can all be funds of funds, and none of them is labeled one on the shelf. Second, the CFTC, the federal regulator of the futures markets, uses the same three words for something narrower, defining a fund of funds as "a commodity pool that invests in other commodity pools rather than directly in futures and options contracts". Everything on this page is about the securities-law sense.

The starting point is a prohibition, not a permission. Section 12(d)(1)(A) of the Investment Company Act makes it unlawful for a registered fund, and any company it controls, to acquire securities of another fund if immediately afterwards it would own more than 3 percent of the acquired fund's total outstanding voting stock, hold securities of that one fund worth more than 5 percent of its own total assets, or hold securities of investment companies generally worth more than 10 percent of its own total assets. Section 12(d)(1)(B) puts the mirror restriction on the selling side. Without relief, those three numbers make a genuine fund of funds impossible.

Why Congress restricted it says more than the numbers do. The SEC's own account is that the restrictions "are designed to prevent fund of funds arrangements that allow the acquiring fund to control the assets of the acquired fund and use those assets to enrich the acquiring fund at the expense of acquired fund shareholders", a practice the release calls pyramiding, and that Congress "also was concerned about the potential for duplicative and excessive fees when one fund invested in another and the formation of overly complex structures that could be confusing to investors". Those three concerns, control, cost and complexity, are still the shape of the current rule.

Rule 12d1-4 replaced a patchwork with a set of conditions. Adopted in 2020 and effective in January 2021, it permits fund of funds arrangements beyond the statutory limits provided the parties meet conditions on each of the three concerns. On control, the acquiring fund and its advisory group must not control an acquired fund, and above stated ownership thresholds must vote their shares in the same proportion as all other holders. On cost, the acquiring fund's adviser must evaluate the complexity and the fees and expenses of the arrangement and find that the acquiring fund's fees and expenses do not duplicate the acquired fund's, reporting that finding to the board. On complexity, the rule generally bars a third tier: a fund may not rely on it to invest above the statutory limits in a fund that is itself relying on it, unless the acquired fund keeps its own holdings of investment companies and private funds within 10 percent of its total assets. Unless the acquiring fund's own adviser also acts as the acquired fund's adviser without being a sub-adviser to either, the funds must enter a written "fund of funds investment agreement", which the rule requires to include the material terms, a termination provision on no more than 60 days' notice, and an undertaking by the acquired fund to provide fee and expense information on request. Adopting the rule, the SEC rescinded rule 12d1-2 and certain exemptive relief that had previously permitted these arrangements.

The layered-cost concern reaches the reader as a line in a fee table, and the detail is worth knowing. Form N-1A requires an open-end fund investing in acquired funds to add a subcaption directly above "Total Annual Fund Operating Expenses", titled "Acquired Fund Fees and Expenses", disclosing the fees and expenses incurred indirectly through those holdings. The instruction carries a threshold: where the indirect fees "do not exceed 0.01 percent (one basis point) of average net assets of the Fund", the fund may include them under "Other Expenses" instead. So the absence of the line does not by itself mean there is no second layer, only that any second layer was under a basis point. The instruction also sets the formula, which builds the figure from each acquired fund's own annual operating expense ratio weighted by the average balance invested and the days held, plus any transaction fees and incentive allocations.

A layered structure is not automatically an expensive one. Where the underlying funds are cheap index funds run by the same firm, and the adviser waives its own fee at the top level, the total can be lower than a comparable single-manager fund. Where the underlying funds are actively managed, or where a fee is charged at both levels for the same work, the arithmetic runs the other way. The fee table is where the question is answered, and the number to compare across funds is total annual operating expenses including the acquired fund line, not the top-level fee alone.

An investor buys shares of the top-level fund. That fund buys shares of other funds, which in turn hold securities. Costs are charged at both levels: the top-level fund's own management, administration and distribution expenses, and the expenses of every underlying fund, which are already deducted from the underlying fund's assets before it reports a value. The prospectus fee table is where the two are added together.

A hypothetical of the arithmetic. Assume a fund of funds charges 0.20 percent at the top level and the acquired funds it holds cost 0.55 percent on a weighted-average basis, so the fee table shows a total annual operating expense of 0.75 percent. On a $50,000 position that is $375 a year: $100 at the top level ($50,000 at 0.20 percent) and $275 inside the underlying funds ($50,000 at 0.55 percent). Only the $100 is charged by the fund the investor bought; the $275 is deducted before the underlying funds report their values and appears on no statement.

Now change one input. If the acquired funds cost 0.008 percent instead of 0.55 percent, the fund is permitted to fold the amount into "Other Expenses" rather than showing an Acquired Fund Fees and Expenses line at all, because the indirect cost does not exceed 0.01 percent of average net assets. The useful reading of that rule is the reverse of the obvious one: a missing line is evidence that the second layer is trivial, not evidence that there is no second layer.

Pros

• One purchase produces a diversified, professionally allocated portfolio, which is why the structure dominates the default options in retirement plan menus.
• Access to strategies or managers an individual investor could not assemble or could not meet minimums for.
• The rebalancing and allocation decisions are made and executed inside the fund, so nothing is required of the holder between purchase and sale.
• The total cost is disclosed in one place, because federal rules require the second layer to be added into the fee table rather than left implicit.

Cons

• Two layers of fees, and the lower one never appears on a customer statement because it is deducted inside the underlying funds.
• Where the acquired funds are actively managed, the layered cost can be substantially higher than a single low-cost fund holding the same markets.
• The structure is opaque about what is actually owned: a holder has to read through to the underlying funds' own holdings to know their real exposure.
• Overlap is easy to create by accident. Buying a fund of funds alongside individual funds can concentrate a portfolio in the same securities twice.
• A missing Acquired Fund Fees and Expenses line can be read as "no second layer" when the rule only means the second layer was under one basis point.