There is a relatively unknown subsection of the investment marketing industry called Funds of Funds (FOF). Recently these collective investment schemes have had some light shown on them as the Madoff scandal continues to disrupt the financial markets. Many of Madoff’s investors were actually FoFs. In this article I will explain what FoFs are and why they are generally a bad idea.

[VIDEO] What is a Fund of Funds?

A FoF is essentially a manager picker. That means that under the pretense of increasing the benefits of diversification the FoF manager will select other top performing fund managers to invest with rather than managing capital themselves. By spreading the FoF’s investors money across several managers the clients should enjoy greater diversification than otherwise available.

This would be great if those benefits actually materialized. The real problem with these funds are that they underperform other diversified investments and they have higher costs. For example, the Barclay’s Fund of Funds index shows that these products have returned 3% on average over the last 10 years compared to 6.83% on the S&P 500 over the same period. This ignores the additional problem of fees and expenses (which are considerable) that a Fund of Funds manager layers on top of the fees already charged by the underlying managers the FoF invests in.

Funds of Funds are illustrative of products that exist primarily for the benefit of the managers but provide little value to investors. There are many examples of this including actively managed funds and ETFs, most hedge funds and many professional advisors. The common denominator amongst these schemes is usually very high costs. In the case of a FoF these fees can be as much as 20% of profits and a percentage of capital invested. I think this is an excellent cautionary tale about considering costs versus benefits whenever you are making an investing decision.