What Is a Fund of Funds?

A fund of funds is a private fund (or sometimes a registered fund) whose holdings are interests in other underlying funds. Rather than selecting individual companies, properties or loans, the manager selects other fund managers and spreads capital across their vehicles.

The structure is common in areas such as venture capital, private equity, real estate and hedge strategies. A related idea is a secondaries fund, which may buy existing interests in funds from earlier investors rather than committing to brand-new funds.

Because there are typically two layers, the fund of funds itself and the underlying funds, there can be two layers of fees and expenses. Reading the offering documents carefully is the way to understand exactly how costs, reporting and terms work.

Many private funds are offered only to accredited investors under SEC Rule 501(a) of Regulation D, so eligibility is often part of the picture.

Traditionally, people have looked at funds of funds as a way to gain exposure to several managers through a single commitment. This can be of interest where access to individual funds would otherwise require large minimums or extensive research.

The approach has often been associated with diversification across managers, strategies or vintage years, along with the manager's ongoing due diligence and monitoring. Others prefer to select individual funds themselves, or to work with a single manager directly. Each path involves different tradeoffs in cost, control and time.

Private fund offerings are typically made under Rule 506(b), which does not permit general solicitation, or Rule 506(c), which permits general solicitation but requires that all purchasers be accredited and that the issuer take reasonable steps to verify that status. Accredited investor categories under Rule 501(a) include individuals meeting income or net worth tests set out in the rule, holders in good standing of Series 7, 65 or 82 licenses (added by the August 2020 amendments), knowledgeable employees of certain private funds, and spousal equivalents. Entities and family offices with over $5 million in assets or investments, as well as registered investment advisers and exempt reporting advisers, may also qualify.

The right fund manager may help you understand how a particular fund of funds is built: how underlying managers are chosen, how the portfolio may be diversified, and how the structure fits within the broader picture of your goals. A good conversation is about understanding, not about being pushed toward a decision.

A first conversation is generally an exchange of information. The manager may describe the strategy and the offering documents, and you may be asked about your situation to see whether you meet eligibility requirements. You are free to take your time and to ask for everything in writing.

Helpful questions to consider: How many layers of fees and expenses apply? How are underlying funds selected and monitored? How often are valuations and reports provided? What are the restrictions on withdrawing or transferring? What tax documents, such as a K-1, should I expect? And what are the main risks? Your own licensed attorney, tax professional and financial adviser can help you weigh the answers.