Investors should ‘warm up’ to funds of funds, Opto says

When investors consider fees, they often choose to avoid funds of funds. However, a recent analysis from Opto Investments, a fintech company for RIAs, says that funds of funds might actually be worth considering.

The analysis published earlier this month argued that the historical performance of funds of funds often justifies the higher fees that come along with them. Funds of funds narrow the range of outcomes in any given strategy and they have been consistent with reduced downside risk.

Funds of funds are pooled investment vehicles that allow investors to access multiple managers and multiple strategies in one place. Essentially, they enable investors to invest in various other funds like mutual funds, hedge funds and exchange-traded funds. The high fees typically include the net fees of the underlying funds, along with management fees.

The result is two-fold. Investors in such funds may earn lower net returns than if they had invested in a single regular mutual fund. On the other hand, they can be a perfect substitute for those who don’t have the patience to watch the markets or don’t have the knowledge to pick from individual funds.

Sure, there are some advantages to the public market, like maximizing returns through minimizing fees and index investing. However, Matt Malone, president and head of investment management at Opto, said the reason for higher fees for funds of funds is also because of operational costs within the private market.

“A lot of these investment strategies and fund managers are actively sourcing and structuring their own underlying deals,” Malone said. “They're not just buying ticker-trading stocks, they're buying companies, they're hiring people, they're developing strategies. There’s a much higher operational cost to doing that. And so there's going to be higher fees.”

He said that no matter the decision, investors should be focusing on a fund’s performance net of fees.

“Both in the public and private markets, you want to be aware of the overall fee load and expense load,” Malone said. “But ultimately, what you're receiving is net-of-fee performance. And if that remains compelling, the fee load should not be the ultimate deciding factor.”

While investors should be focusing on understanding the overall expenses of any investment vehicle, it would be wise to know the fees are in line with the service and value that the manager is providing.

Malone provided a few ways to mitigate the high fees that come with funds of funds.

“If you're a good FOFs manager and have some scale, you may be able to negotiate lower fees with the underlying fund managers,” he said. “The private market strategies generally have wide bands of outcomes for investors. So you're going to have a much different experience if you invest in a good private equity fund versus investing in a bad private equity fund. A lot of times, investors don't have the expertise to do that themselves.”

Before ultimately deciding to invest in a funds of funds, Malone said it’s important to do the background work first.

“If you do your homework and the FOFs manager is adding enough value to outweigh the potential additional fees, then it's worth it,” he said. “If you don't have that expertise, it helps you avoid some potential bad outcomes while still getting exposure to the asset class.”