Fund of funds (FOF) are an increasingly popular instrument in the world of investments, where a pooled fund is used to invest in other funds, such as hedge funds or mutual funds. Affectionately referred to as an “FOF,” the fund of funds strategy is an effort to achieve broad diversification and minimal investment risk by utilizing the collective wisdom of investing professionals.

At its core, an FOF is similar to any other type of mutual fund. It is a collection of diverse investments within one portfolio managed by a professional. However, the primary difference is that FOFs invest in multiple asset classes, rather than just stocks and bonds like a traditional mutual fund. Instead, it may invest in multiple hedge funds, small-cap stocks, private equity firms, venture capital groups, and even other FOFs. This diversification reduces exposure to market risk.

For investors, FOFs involve higher costs due to their higher expense ratios than traditional mutual funds. This is primarily because of administrative costs associated with managing the types of diversified investments that an FOF typically includes.

Given their decreased exposure to risk, FOFs can provide better returns over the long-term, even with the increased costs. Their increased flexibility in terms of the asset classes available for investment can result in greater returns, and because FOFs involve the expertise of professional money managers, the quality and expertise of the portfolio can be quite high.

For those with limited capital, investing in an FOF may also be a good way to gain exposure to a variety of asset classes and market sectors. By investing in an FOF, investors can gain a diverse exposure to the markets with a single instrument, helping to make their own portfolio more balanced and efficient.

In short, funds of funds offer investors an attractive option to achieve broad diversification, control risk, and benefit from the expertise of professional money managers. While the cost may be higher than traditional mutual funds, the long-term returns may often justify the higher expense ratio. This is especially true for those with limited capital and investment experience, as an FOF can provide access to a wide diversity of assets and markets.