By |Published On: June 24th, 2018|Categories: Basilico and Johnsen, Academic Research Insight|

Fund of Funds Selection of Mutual Funds

  • Edwin Elton, Martin Gruber and Andre de Souza
  • Critical Finance Review, forthcoming
  • A version of this paper can be found here
  • Want to read our summaries of academic finance papers? Check out our Academic Research Insight category

What are the Research Questions?

Unlike individuals, managers of Fund of Funds devote their full professional effort to this task. Additionally, those who invest in funds within their own fund family have access to information not available to the general public.

The authors investigate the following:

  1. Do managers of Fund of Funds show superior abilities in selecting active funds?
  2. Do Funds of Funds managers select funds primarily to satisfy family and manager objectives and therefore select poorer performing funds? These different objectives are as follows:
    1. Start date- the family might want to help startup funds
    2. Expenses- higher expense funds bring in more money to the family.
    3. Total net assets- management might select funds to include which are smaller than the alternatives to help these funds reach a scale where they are profitable.
    4. Management objectives- select a fund when the manager manages it on top of Fund of Funds

What are the Academic Insights?

By studying all funds that were identified by Morningstar as a Fund of Funds and that were sold in the United States over the period 2002 to 2015, the authors find that

  1. NO- Fund of Funds that are part of a fund family select mutual funds  underperform (20 bps per year) a random selection (this is not due to selecting a higher cost alternative) . In contrast, Fund of Funds that are not part of a Fund family do much better (40 bps per year). Interestingly, when a Fund of Funds manager selects an active fund offered by the family to which the Fund of Fund belongs compared to all active funds offered by the same family in the same Morningstar category, the average alpha on the fund selected is  34bp per year less than the average fund offered by the fund family in the same Morningstar category, and only a very small portion of it is due to higher expenses.
  2. YES- The underperformance of the group most likely to be pursuing family or manager objectives explains 55% of it. The extra information managers may have about funds within their family is more than out weighted by family and manager goals.

Why does it matter?

Over the sample period studied, the authors find that between 51% and 77% of Funds of Funds only invest in funds within the family to which they belong, while between 14% and 27% invest only outside their family. It appears that Funds of Funds are hurting investors when they select funds in general and when they select funds from their own family. While managers of Fund of Funds may have access to special information any benefit from this appears to be outweighed by fund family or manager objectives.

The Most Important Chart from the Paper

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index.

Table 4  shows for active funds the differential alpha and expense ratio in percent per month between the funds held by a Fund of Funds and all other funds in the same Morningstar category. The differentials are averaged each year and then across all years for each Fund of Funds.  The last row shows how much higher the differential alpha is for all outside compared to principally inside. In other words, Fund of Funds that principally invest inside the family do worse than random selection of funds of the same type. Fund of Funds that invest principally inside do worse in selecting funds than funds that only invest outside of the family offering the Fund of Funds.


Managers of Fund of Funds have access to information not available to the general public in evaluating funds from their own family. However, they may have family or self-serving motives that can hurt shareholder performance. By examining a history of individual transactions of Funds of Funds, we show that managers of Fund of Funds despite access to non-public information select individual funds that underperform random selection. Much of this underperformance is shown to be explained by managers satisfying a specific set of family and management goals. Fund of Funds that invest exclusively outside their fund family do not face these family and management goals and they outperform funds of funds that invest inside the family.

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About the Author: Wesley Gray, PhD

Wesley Gray, PhD
After serving as a Captain in the United States Marine Corps, Dr. Gray earned an MBA and a PhD in finance from the University of Chicago where he studied under Nobel Prize Winner Eugene Fama. Next, Wes took an academic job in his wife’s hometown of Philadelphia and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management firm dedicated to an impact mission of empowering investors through education. He is a contributor to multiple industry publications and regularly speaks to professional investor groups across the country. Wes has published multiple academic papers and four books, including Embedded (Naval Institute Press, 2009), Quantitative Value (Wiley, 2012), DIY Financial Advisor (Wiley, 2015), and Quantitative Momentum (Wiley, 2016). Dr. Gray currently resides in Palmas Del Mar Puerto Rico with his wife and three children. He recently finished the Leadville 100 ultramarathon race and promises to make better life decisions in the future.

Important Disclosures

For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Third party information may become outdated or otherwise superseded without notice.  Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency has approved, determined the accuracy, or confirmed the adequacy of this article.

The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).

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