When building an investment portfolio, mutual funds are a popular choice. Investors looking for diversification often debate between picking individual mutual funds or investing in a fund of funds. Both options have advantages and disadvantages. Understanding the key differences between these two approaches can help you make an informed decision.
How Mutual Funds Work
A mutual fund pools money from many investors and purchases a portfolio of securities like stocks and bonds. The fund is managed by professional investment advisors who select and manage the mix of assets. When underlying investments generate dividends, interest, or capital gains, these earnings are passed to mutual fund investors. The value of the mutual fund shares rises and falls based on the performance of the underlying portfolio. Mutual funds provide instant diversification across various assets.
Benefits Of Mutual Fund Investing
Mutual funds have become popular because they offer investors some key benefits, including:
- Instant diversification with even a small investment amount
- Access to professional investment management expertise
- Flexibility to adjust your asset allocation as needed
- The convenience of letting the fund handle purchases and sales
- Automatic reinvestment of dividends and capital gains
For novice investors or those with limited time, mutual funds offer an easy way to participate in the financial markets.
How Funds Of Funds Work
A fund of funds takes the concept one step further. As the name implies, a fund of funds invests in shares of other mutual funds rather than individual securities. For example, a fund of funds may hold positions in various stock, bond, and money market funds to create a balanced portfolio.
The fund of funds provides an additional layer of diversification. Instead of owning shares from many companies, you own shares in mutual funds that each own a diverse mix of securities.
Explaining Funds of Funds
Funds of funds operate much like regular mutual funds. An investment manager selects a basket of mutual funds to invest in to achieve a desired asset allocation. The fund of funds pools investor money to buy shares in its chosen selection of mutual funds. It passes along the underlying mutual fund dividends and capital gains to the investors in the fund of funds. The share price reflects the blended performance of all the underlying funds.
Like an individual mutual fund, a fund of funds offers built-in diversification, professional management, and convenience. The key difference is that it provides an extra level of diversification by investing in multiple mutual funds rather than individual stocks and bonds.
Pros Of Investing In A Fund Of Funds
Some potential benefits of investing through a fund of funds include:
- Further diversification into more mutual funds
- Automatic rebalancing across asset classes
- Potentially lower expenses than buying many funds yourself
- Still benefits from professional management
For a hands-off approach to asset allocation, a fund of funds offers broad diversification in a single investment.
Cons Of Investing In A Fund Of Funds
Some downsides of a fund of funds to consider include:
- An additional layer of fees from underlying funds
- Less transparency into the specific holdings
- Potential “over-diversification” resulting in muted returns
- Higher tax liability if underlying funds have high turnover
If lower costs and maximum control over asset allocation are priorities, a fund of funds may be less suitable.
This is a complete fund of funds explained.
Mutual Fund Vs. Fund Of Funds: Which Is Better?
There is no definitive “better” option. It depends on your investment priorities and preferences. Investing in individual mutual funds allows customizing your portfolio and provides transparency into the holdings. However, it requires more effort to research and select multiple funds. A fund of funds sacrifices some control but offers extreme simplicity. Compare costs, asset allocation, and tax efficiency to decide which strategy fits your needs. Or consider holding some individual funds along with a fund of funds to get a blend of diversification and control over your portfolio.
About Author
- I’m a firm believer that information is the key to financial freedom. On Coindecimal Blog, I write about personal finance and crypto.
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