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Are there mutual funds made up of other mutual funds?

QUESTION: I was wondering if there are mutual funds made up of just mutual funds. Wouldn't that be an even better way to diversify? If there are, can you direct me to more information on these?

-- Sam Aguilar

ANSWER: Fund-owning mutual funds do exist. In fact, investors have 138 "funds of funds" to choose from, according to fund-tracking firm Morningstar. Of course, with a mutual-fund universe of more than 8,000 funds, it's easy to see how this small group could get lost in the shuffle. So here's a quick tutorial on their benefits and drawbacks.

As you suspected, funds of funds are designed to give investors broad diversification with a single portfolio. This can be particularly appealing to someone who's unsure of how to diversify on his or her own. The average fund of fund holds 10 portfolios, which can range in nature from domestic to foreign funds, large-cap to small-cap funds, as well as fixed-income funds. "It's the whole gamut of investments in one package," says Peter Di Teresa, senior analyst at Morningstar.

For investors just starting out or for those with only a small amount to invest, funds of funds can be quite handy. Consider that the Vanguard STAR fund (VGSTX), which holds 11 other Vanguard funds, requires a modest minimum initial investment of $1,000. "Automatically you have broad diversification" at a very low cost, says Di Teresa. A low-budget investor could then slowly invest more money into the fund through an automatic investment plan (AIP), which allows additions of as little as $50 at a time.

Funds of funds are often tailored to a specific need, such as growth or income. Many of these portfolios are also created to suit an individual's risk tolerance -- something that Morningstar classifies as a "lifecycle" fund. Among Vanguard's LifeStrategy portfolios, for example, LifeStrategy Growth (VASGX) would suit a more aggressive investor -- although like almost all lifestyle funds, it's fairly tame when compared with true aggressive-growth funds. Alternatively, a more conservative investor might go for LifeStrategy Moderate Growth (VSMGX), LifeStrategy Conservative Growth (VSCGX) or even LifeStrategy Income (VASIX).

A slight twist on these lifecycle funds is the "target retirement" funds, which are funds of funds specifically geared toward an investor's retirement timeline. Fidelity Freedom 2030 (FFFEX), for instance, is designed for investors who plan to retire around the year 2030. This fund, which currently holds 17 Fidelity funds, changes over time, becoming more conservative as its target year approaches.

Not all funds of funds are specifically geared for risk tolerance or retirement horizon. For example, T. Rowe Price Spectrum International (PSILX) simply holds various overseas funds, from half of its assets in T. Rowe Price International Stock (PRITX) to a small stake in T. Rowe Price Emerging Europe & Mediterranean (TREMX).

You should also know that there can be a downside to these all-in-one investments. Many funds of funds have two layers of fees: one for the fund itself, and a second for the funds it owns. These combined figures often aren't included on a fund family's Web site, so be sure to ask about the combined total expense ratio before you invest. The good news is that several major fund firms, including TIAA-CREF, T. Rowe Price and Vanguard, only charge investors fees for the underlying portfolios, not the fund of funds itself. For example, Vanguard STAR sports a 0% expense ratio, although the funds it owns cost shareholders 0.37% last year.