Fund of Funds are growing in popularity as part of the worldwide default structure of many collective vehicles for long term savings. In this article, we’ll explore the different characteristics of Fund of Funds (FoF) and the FoF markets in the United States, United Kingdom and Australia.

What is a Fund of Fund?

An FoF is generally an open-ended collective investment scheme (a “Fund”), which invests in a portfolio composed of shares or units of other Funds, let’s call them Building Block Funds (“BBFs”), rather than investing directly in stocks, bonds, or other securities. The BBF’s may be funds from the same investment manager or may be funds from multiple investment managers. In the latter case, the FoF is called a “multi-manager’ fund.

The reason for creating an FoF is that it gives the fund sponsor great flexibility in the following areas:

  • It’s easy to change the asset allocation of the FoF, e.g. reduce equity exposure and increase bond exposure.
  • Replacing a poorly performing asset manager managing one of the BBFs is easy, e.g. sell the units in the equity BBF held by the FoF and buy BBF units in an equity fund managed by high performing manager.
  • Switching between passive and active managers is easily achieved.
  • To reduce transaction costs as fewer assets are required versus direct investment.

United States of America FoF

In the US market the most widespread type of defined contribution plan is the 401(k) plan. Most 401(k) plans offer a package of FoF’s which are called Target Date Funds (“TDFs”). At 31 Dec 2019, it’s estimated the total AUM of 401(k) plans invested in TDFs was USD$2.3 trillion.

A TDF is a fund that automatically rebalances its exposure to different asset classes over time. It generally starts with a large exposure to higher risk growth assets such as equities and property when the investor is younger and rebalances to a higher exposure to lower risk income yielding assets such as bonds as the investor approaches the target date of their retirement. TDF’s offer investors the simplicity of both investing their retirement savings in a single TDF and not having to revisit asset allocation decisions every year.

A TDF with a target date of say calendar year 2060 might start the equity BBF at 80% of the TDF value and the bond BBF at 20% of the TDF value and rebalance the allocations over the period to 2060 so that the equity BBF is 10% of the TDF value and the bond BBF is 90% by 2060. This rebalancing occurs automatically in the TDF. In the US TDF’s are normally in 5-year bands, e.g. 2021-2025, 2026-2030…

TDF’s greatly simplify administration of occupational pension plans for the trustees and administrators. The alternative approach is to have every member of the plan invest in say five funds to create an age-appropriate asset allocation. The holdings in these five funds must be rebalanced for every member every year and the new contributions have to be allocated in different proportions each year. The trustees must write to each member to explain the rebalancing and redirection of new contributions each year. All of this member administration is eliminated when TDFs are used which reduces cost and potential errors in member administration.

The other alternative of putting the majority of members of all ages into a default/balanced fund does not appear to be appropriate investment advice for pension plan members.

United Kingdom FoF

In the UK, the National Employment Savings Trust (“NEST”) (setup by the UK government to facilitate auto-enrolment of employees into a defined contribution occupational pension scheme) has a TDF for every future year of retirement.

NEST uses a range of collective funds from external asset managers for its BBF’s. The annual management charge/ total expense ratio for its funds is 0.3% p.a.

Fund Factsheets

In the UK, life assurance companies offer FoF (sometimes called Blended Funds) to meet the specific needs of occupational pension schemes. Some of these companies also offer TDF’s similar to NEST.

The trustees of occupational pension schemes will generally use employee benefit consultants to advise them on a suitable blend of assets to meet the specific liabilities of their pension scheme (these may be defined benefit or defined contribution schemes).

The employee benefit consultant will then work with a life assurance company that will create a FoF specifically designed to meet the liabilities of that pension scheme. In some cases, multiple FoF’s will be created to meet the different needs of different members of the same scheme. The employee benefit consultant can not only specify the asset allocation for each FoF but also the asset manager for the BBFs.

Australian FoF

In Australia, all Superannuation schemes (these are defined contribution occupational pension schemes where the employer currently contributes a minimum of 9.5% of salary for each member) offer their members a range of FoF, generally called Investment Options funds.

The Investments Options funds are a mix of balanced funds with varying degrees of risk from high risk to low risk. Some offer their members the ability to pick their own funds from the range offered but the majority (c90%) of superannuation members are invested in the medium risk-balanced fund option.

The Investment Option funds are FoF which invest in sector-level funds. The sector level funds are the broad asset classes, e.g. equity funds, property funds, bond funds etc. Each sector level fund is an FoF that will invest in specific asset class funds, e.g. the equity sector fund will invest in multiple equity funds, e.g. a US equity fund, a European equity fund etc. Each equity fund, e.g the US equity fund, may itself be an FoF as it may have multiple portfolios where each portfolio has a different asset manager or may invest in a range of external collective investment funds or some combination of both.

The AUM in Australian Superannuation schemes (excluding public sector schemes and schemes with less than five members) at 31-12-2019 was A$1.5tn ($1.1tn) is typically managed in this 4-layer FoF structure.

For a deeper dive into Fund of Funds, including the challenges in managing and rebalancing FoF and the role of automated investment administration software in reducing the operational risk and increasing efficiency in FoF, download the white paper: Fund of Funds Global Adoption and Investment Administration Best Practice.

Peter Caslin is the CEO and a founder of Financial Risk Solutions. Peter is a Fellow of the Society of Actuaries in Ireland.