A fund of funds works the same way as actively managed investment funds, except they're choosing other investment funds.
The first problem is obvious: Unnecessary middlemen. The fund of funds manager is likely taking a fee akin to the average ETF, that is about a half a percent a year, plus a cut of the profits. And the funds he invests in may be hedge funds that are taking 2% of assets plus a cut of the profits. It's easy to see how even if these guys can beat market averages, you will not beat the average since all that money will likely be consumed in fees.
The bigger problem is the Ponzi-like payoffs this sort of system can have. Investment is a money multiplier, that is the money is counted on your books, the investment fund's books, and the company ultimately invested in. Fund of funds trading with each other can drive up their own AUM, increasing their cut. This was a small part of the FTX fraud, where they actual invested in at least on of the private equity firms that invested in them.
There's no fundamental need for funds of funds to exist, and the room for potential abuses is great. Heck, even ETFs are a bit redundant if you have a lot of investments, since you can simply skip the fees and buy all the underlying businesses. I once found one fund of funds whose reported fees added up to a grand total of over 10% a year.
In my garbage opinion, I think registered investment funds should be barred from putting customer funds into other registered investment funds. Clarifying, I don't mean shares of the company, but the funds themselves. I.E. An investment fund will be able to buy shares in Blackrock, but won't be able to buy IVV (Blackrock's biggest fund).
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