Investment product selection involves many variables, but one area that requires a balancing act is the trade-off between affordability, diversification and sophistication.
“Everyone wants the holy trinity of better, cheaper and faster, but you usually get only two,” says Michael Ashley Schulman, chief investment officer of Running Point Capital Advisors.
Whether it’s due to accredited investor requirements or high minimum capital commitments, some strategies, especially hedge funds or those that invest in private assets, are simply not available to most retail investors.
To navigate this, investment managers have long used a “fund of funds” structure. At its core, this just means a fund that holds a collection of other funds inside it.
And any time middlemen insert themselves into the process, you can expect fees to go up. But how much they go up and whether that’s fair depends heavily on the types of assets being used and how the structure is put together.
“At first, an investor might immediately reject the idea of paying an extra layer of fees,” says Jack Gunn, director and wealth advisor at Ullmann Wealth Partners. “But one should take a closer look, as the universe is quite nuanced.”
What might be reasonable for one investor could be prohibitively expensive for another. Here’s what you need to know to make an informed decision when it comes to fund-of-funds fees.
The first layer of fees starts at the top: The fund of funds itself may charge a management fee, usually expressed as a percentage of assets under management. That’s just the beginning.
The underlying funds held within the portfolio also charge their own management fees. These are not included in the fee charged by the fund of funds and are instead embedded within the holdings. While they vary, you, the investor, bear the cost of all of them.
But it doesn’t always end there. Some funds may also charge performance-based fees. These are common when the fund of funds includes actively managed strategies. Performance fees are usually calculated as a percentage of the gains earned above a specified benchmark.
Some funds include a hurdle rate, meaning the manager only earns a performance fee if returns exceed a certain percentage threshold. Others may use a high-water mark, meaning the manager can only earn a performance fee if the fund’s net asset value surpasses its previous highest level. This ensures investors aren’t paying for repeated gains on previously lost ground.
To recap: When you buy a fund of funds, you pay it a management fee. You also pay the management fees borne by the underlying funds it holds. If these funds also charge performance fees, you may further forgo a percentage of any gains they generate above the stated benchmark.
Altogether, these layered fees can quickly stack up, and that’s before accounting for any taxes owed on distributions or capital gains. Even if the investment performs well, the combined effect of stacked fees can materially eat into your net returns.
“Ask yourself if a particular fund of funds has historically outperformed another comparable investment with lower fees,” says Anessa Custovic, chief investment officer at Cardinal Retirement Planning Inc. “If the answer is yes, then it might be worth adding it into your portfolio, but for most investors these may not be appropriate investments.”
That being said, there are generally two situations when paying fund-of-funds fees might be justified. The first is when you want exposure to a particular fund or manager but can’t access them directly.
This often happens in private equity, where the best-performing funds are typically closed to new investors or demand minimum investments of millions of dollars or more. Even if you have the capital, you may lack the connections or timing to get in.
A fund-of-funds structure solves this by pooling money from multiple investors, allowing the general partner to negotiate access and secure an allocation. You, as a limited partner, get exposure, just with an added fee.
“While paying a fee on top of the manager’s fee is not ideal, there are cases where it can make sense, especially if the sponsor of the fund of funds has extensive experience, a deep research team performing due diligence and access to top managers,” Gunn explains. “Many times, these managers are not available to individual investors, and if they are, they require high minimum investments.”
The second case is when the underlying funds provide access to hard-to-source or exotic assets. That might include private equity and venture capital, and also privately held real estate investment trusts, direct lending strategies to mid-market companies (private credit) or infrastructure deals.
These types of investments are not only hard to find, but often require expert due diligence and legal structuring. The general partner of the fund of funds typically has the experience, research capability and sourcing network to handle this. You pay for that access and expertise, but in exchange, you get a seat at a table that would otherwise be out of reach.
The situation gets a bit more nuanced when you’re dealing with mutual funds that hold other mutual funds, or ETFs that hold other ETFs. In these cases, the fund-of-funds structure can work well, especially in the context of all-in-one portfolio solutions.
For mutual funds, the fund-of-funds setup is most commonly seen in target-date funds. These are designed to automatically adjust your asset allocation based on a projected retirement date.
Take the Vanguard Target Retirement 2060 Fund (VTTSX), for example. It currently invests in four underlying Vanguard equity and bond mutual funds.
The “acquired fund fees and expenses” for VTTSX sit at just 0.08%, which is how much you indirectly pay for those underlying funds. That’s a far cry from the 2%-plus fees you might see in private fund-of-funds structures and shows how efficient this approach can be at the retail level.
Not only are there minimal layers of duplicate fees here, but VTTSX simplifies things by automatically managing the stock-to-bond ratio over time. And because Vanguard uses its institutional share classes as the underlying holdings, typically reserved for large investors with steep minimum investments, you get the benefit of low costs with a minimum investment of just $1,000 via VTTSX.
The same principle applies on the ETF side. A good example is the iShares Core Aggressive Allocation ETF (AOA), which follows an 80-20 stock-bond mix by holding other iShares ETFs across U.S. and international equity and fixed-income markets.
AOA breaks its costs down clearly: a 0.15% management fee, 0.04% in acquired fund expenses and a 0.04% fee waiver that brings the net expense ratio back to 0.15%. In short, iShares is eating the underlying ETF costs so investors just pay the advertised 0.15% all-in.
“You could technically save a few basis points building this yourself,” Schulman says. “But for many investors, the convenience and efficiency of one-stop shopping and automatic rebalancing is worth paying up for.”
The setup used by VTTSX and AOA is much more cost effective than the multi-layered fee structures found in alternative asset funds of funds. You’re paying a modest fee for a one-ticker solution that provides broad diversification, institutional pricing and automated rebalancing.