Fund of Funds

Mutual funds have become quite popular among investors as they offer higher returns, professional management, flexibility and lower risk. So, instead of sticking to just one mutual fund, you even have the option to invest in a mix of mutual funds by choosing a fund of funds (FoF). This article will detail the types, benefits and drawbacks of FoFs.

What is Fund of Funds?

Fund of funds is an investment strategy wherein a mutual fund scheme invests in other mutual funds rather than stocks, bonds or other securities. In simple terms, FoFs use the capital pool to invest in various mutual funds or hedge funds. 

FoFs can invest in mutual fund schemes offered by the same or different mutual fund houses.

Fund of funds aims to achieve diversification at minimal risk while maximising returns. They generally have higher expense ratios because investors pay fees at both the FoF level and for the underlying funds it holds. Additionally, the costs of managing a diverse portfolio and specialised fund selection contribute to the increased expenses.

FoFs can invest in both domestic and international funds, as per the preferences of the asset management company. This activity increases the heterogeneity, which results in increased diversification in the portfolio. 

How Does a Fund of Funds Work?

The working of fund of funds is quite straightforward. An investor contributes funds to a FoF which are then allocated to different mutual funds by a dedicated fund manager. Since FoF is an actively managed fund, the fund manager’s expertise is crucial for the success of the scheme. The main objective of the fund manager is to pick the right mix of various funds to strike the balance between risk and return.

Types of Fund of Funds

These are the top fund of funds available to investors:

Asset Allocation Funds: These are balanced mutual funds, wherein investors put their money into a diverse asset pool. This type of FoF holds various funds investing in equities, debt instruments, precious metals, etc. Seasoned investors use this strategy to redistribute their risk and boost potential returns.

Gold Fund of Funds: Gold is a precious metal, and its value is bound to increase with time. A gold fund of fund invests in different types of mutual funds that have exposure to gold in multiple forms such as physical, digital, gold ETFs and even stocks of gold mining companies. A gold FoF can give exposure to a variety of gold mutual funds. 

International Fund of Funds: International Funds of Funds invest in mutual funds that operate in foreign countries. This allows investors broad exposure to international stocks, bonds and assets. They are used to yield high returns by investing in the best-performing stocks and bonds of the respective country. International FoF creates global diversification in the portfolio by exploring opportunities beyond the domestic market.

Multi-manager Fund of Funds: A multi-manager fund of funds invests in several different funds, each managed by a separate investment manager. This approach aims to combine the expertise of various managers to potentially enhance returns and manage risks. These are the most common fund of funds.

Hedge Fund of Funds: These FoFs invest in a portfolio of hedge funds, which improve investment performance and insulate returns from market risk. Hedging is a strategy that tries to limit risks in financial assets. It uses financial instruments or market strategies to offset the risk of any adverse price movements. Hedge fund of funds provides investors with exposure to a diversified range of hedge fund strategies to secure their investment.

ETF Fund of Funds: This type of FoF invests in a portfolio of other exchange-traded funds (ETFs) rather than individual stocks or bonds. This is a more accessible way of investing in ETFs than a direct investment because directly investing in ETFs requires a Demat account while investing in an ETF fund of funds has no such limitations.

 Private Equity Fund of Funds: These FoFs invest in a portfolio of private equity funds, which invest in private companies. Private equity funds allow investors to participate in the potential growth and returns of private equity investments.

Each type of fund of funds has different investment objectives, strategies and assets as per the discretion of the asset management company. Investors should pick the type of FoF that meets their investment goals while bearing minimal risk.

Advantages of Investing in FoFs

Let’s take a look at the advantages of investing in the best fund of funds:

Diversified Portfolio: A fund of funds offers investors diversification benefits as it invests in some of the best-performing mutual funds, providing exposure to various asset classes, sectors, and global markets. This strategy spreads risk across investments and stabilises the fund’s performance.

Professional Management: Fund of funds are managed by professionally trained fund managers who have the acumen to properly analyse the market conditions and invest in strategies that can generate high returns for investors. It saves the hassle of doing your own research and continuous monitoring of investments.

Low Resource Requirement: A small investor with limited resources can use a fund of funds to diversify investments more easily and cost-effectively than trying to invest in different asset classes on their own.

Disadvantages of Investing in Fund of Funds

Fund of funds also have a few drawbacks, such as:

High Expense Ratio: Expense ratios are the cost that an asset management company charges for managing a fund. FoFs have a higher managing expense than regular mutual funds leading to a higher expense ratio. Besides the general management fees, FoFs will also have an added cost for the underlying funds. These expenses together can be substantial and eat a part of your returns.

Over Diversification: Since a fund of funds invests in different mutual funds that in turn hold a range of securities, it can so happen that one ends up owning the same stocks or instruments through different funds. This can result in the concentration of holdings, thereby reducing the diversification potential.

Degree of Risk in Fund of Fund

The investment strategy of a fund of funds involves portfolios with varying degrees of risk tolerance, determined by the investment manager's objectives. If the primary aim of the portfolio manager is to maximise returns or earnings, the FoF will target funds with higher net asset values (NAVs), even if they come with higher risk. Conversely, if the goal is to achieve stability, the manager will invest in lower-risk instruments using the pooled financial resources.

A FoF may be "fettered," meaning it invests exclusively in portfolios managed by a single investment company. Alternatively, it may be "unfettered," allowing it to invest in funds managed by different AMCs.

Who should Invest in Fund of Funds?

According to experts, smaller investors who have limited financial resources but want access to a range of asset classes or funds can look to invest in fund of funds. This way they can reap the benefits of diversification. FoFs are also suitable for individual investors who lack the time or expertise to research and manage a diverse portfolio. This way they can achieve broad market exposure.

Additionally, FoFs help reduce risk through diversification, offering a more balanced approach that can lead to solid returns. For those seeking to grow their investments safely, FoFs can be an ideal investment option.

Factors To Consider While Investing in FoFs

While picking a fund of fund, you need to consider these factors:

Cost Involved: Examine the complete cost and fee structure, including the total expense ratio of both the FoF and its various underlying funds, as higher fees can lower your returns.

Historical Performance: Analyse the past performance of the fund of funds to get an idea of how they have fared during different periods, especially when the markets have done poorly.

Quality of Fund Manager: FoFs are actively managed and significantly impacted by the quality and acumen of fund managers. Consider their investment strategy and performance while selecting the FoF.

Tax Considerations: Evaluate the tax implications on your FoF, including any capital gains tax, and how it fits in your overall tax planning.

Investment Variety: Assess the FoF’s asset allocation and fund diversification by looking at the funds that FoF has taken exposure to.

Taxation of Fund of Funds

The Budget 2024 has introduced changes to how mutual funds will be taxed, which impacts FoFs as well. Let’s understand this detail.

Equity FoFs: A fund of funds is classified as an equity fund if it invests 90% of its assets in funds that, in turn, invest 90% of its assets in domestic equity.  

Debt FoFs: A fund of funds will be categorised as a debt fund if it allocates at least 65% of its assets to other funds that, in turn, invest at least 65% of its assets in debt and money market instruments. These funds are taxed at the applicable income tax slab rate irrespective of the holding period.

Other FoFs: These funds don’t fall in the category of either equity FoF or debt FoF. 

How to Invest in FoFs?

If you are looking to invest in FoFs through INDmoney app, follow these steps:

• Open the app and log in with your credentials.
• Navigate to the "Mutual Funds" section within the app.
• Use the filter options to select "Fund of Funds" to view the available choices.
• Decide between a lump sum investment or a Systematic Investment Plan (SIP) for regular investments.
• Enter the desired investment amount and confirm the transaction.