Fund of funds

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A fund of funds is a mutual fund which holds other mutual funds, rather than individual stocks or bonds.

General recommendations

Funds of funds are excellent investments for getting started in an IRA or 401(k) because they offer a complete portfolio for a small investment. Often, the best way to start an IRA is with the appropriate Vanguard target retirement funds; you can always change to a more complicated portfolio later.

It is normally best to avoid a fund of funds in a taxable account, although it would be possible to hold a Vanguard target retirement fund in a portfolio which is entirely taxable, getting the simplicity of management in return for a small tax cost.

Advantages

The most important advantage of a fund of funds is simplicity. A fund of funds that is a balanced fund is normally suitable for your entire portfolio, and requires no management as long as its allocation remains appropriate for you. With this in mind, Vanguard makes the Vanguard target retirement funds and STAR fund available with a minimum of $1,000, in contrast to the $3,000 required for all other funds.

Funds of funds provide an easy way for a fund company to provide a single, broadly diversified fund without the need for separate management, and make a broadly diversified portfolio available to small investors. In particular, it is possible to offer a series of funds which hold the same funds in different proportions; the Vanguard LifeStrategy funds and Vanguard target retirement funds are examples.[note 1] Target date retirement funds from other fund companies are also usually funds of funds.

Disadvantages

Possible extra expenses

Vanguard's funds of funds do not add an extra expense, but some fund companies do charge an expense in addition to the expenses charged by the underlying funds. To see whether there is such a fee, look at the prospectus; acquired fund fees and expenses are the expenses charged by the underlying funds, while any other fee is a separate expense charged by the fund of funds. There is no point in paying such an expense, as the management is not doing anything you could not do easily by yourself; you could hold the underlying funds, rebalance to the appropriate allocation regularly, and save the fees.

Even with Vanguard, the funds of funds have no lower cost Admiral classes; if your IRA grows large enough for Admiral shares, you may want to switch. (Note that in a corporate retirement plan, you may not have Admiral shares available, or may not even have all the underlying funds available.)

Taxes

A fund of funds must pass on all capital gains distributed by the underlying funds, and cannot use the losses. It may also have to pay out its own gains when it rebalances, although many funds of funds can use new investments to rebalance and thus avoid distributing gains. Thus a fund of funds is more likely to distribute capital gains than a balanced fund with similar holdings.[note 2]

As of 2010, the Regulated Investment Company Modernization Act of 2010 [1] allows funds of funds to pass on the foreign tax credit from the individual funds to their shareholders.

Vanguard funds of funds

Balanced funds

All-stock funds

See also

Notes

  1. For a comparison between the Life Strategy Funds and the Target Retirement Funds, refer to Vanguard funds: life strategy funds vs target retirement funds.
  2. Taxable distribution histories of Vanguard fund of funds are available at:

    These distribution histories can be compared to Vanguard indexed and tax-managed balanced fund distribution histories:

    Taxable distribution histories of Vanguard All-Stock fund of funds are available at:

References