Funds of Funds provide Diversity for a Price

Mutual funds can provide investors access to a wide variety of products and offer professional financial management, but special aggregates called funds of funds may take these strategic advantages to the point of diminishing returns.

A fund of funds invests in a variety of underlying mutual funds and affords investors greater diversification that a single mutual fund, but the broadly allocated portfolio does come at a price. Owners of funds of funds typically pay double management fees, those charged by the underlying funds as well as the fees charged by the manager of the fund of funds. The benefits of diversification can also become highly diluted in a fund of funds that has invested in dozens of underlying mutual funds. A fund of funds can become so broadly diversified that it begins to act like an index fund, which is invested to passively track a market sector. Owners of funds of funds may be paying multi-manager fees in exchange for a performance associated with passively managed funds that charge relatively low fees.

The benefits of diversification were established by pioneer economists who developed modern portfolio theory. According to the theory, diversification minimizes investment risk by spreading it over a variety of investments, such U.S. stocks, government bonds, corporate bonds and international investments. A highly diversified portfolio tends to be less volatile because market conditions that work against one investment class can favor another so that losses in one category can be balanced by gains in another.

Diversification, as well as risk, make up the top investment concerns of America’s wealthiest investors. Millionaires, who make up a savvy and sophisticated group of investors, say it’s extremely important for beginning investors to understand the basic investment concepts of diversification and risk.

Nearly all – 97 percent – of investors with $5 million or more say it is important for a young adult learning to invest to develop an understanding of their tolerance for risk and the role risk plays in an investment portfolio. An investor with little tolerance for risk, for example, would be considered conservative and would invest in safe products such as federally insured certificates of deposits so as to not place any of their assets at risk.

Millionaires say it is equally important for a beginner who wants to learn to invest to understand diversification, the practice of allocating assets over a wide variety of investment products to achieve maximum gains with minimum risk. According to the U.S. Securities and Exchange Commission, “Diversification is an investing strategy that can be neatly summed up as ‘Don’t put all your eggs in one basket’.”

The SEC issued new rules five years ago to make the fees charged by funds of funds more transparent to consumers. The fees charged by a fund and the taxes that result from trading within the funds diminish investment returns, said the SEC. The agency provides investors a mutual fund cost calculator to determine exactly how much mutual fund costs will lower returns.

It’s also important to remember that mutual funds are not guaranteed or insured by the Federal Deposit Insurance Corporation or any other government agency. Investors can and do lose money investing in mutual funds, says the SEC.