Fund of Funds (FOF): Meaning, Types & Advantages

What Does Fund of Funds Mean?

What are fund of funds schemes? Simply put, they are a type of mutual fund scheme that invests in other mutual fund schemes. Hence, instead of holding a portfolio of equities or bonds, the fund manager of a fund of funds scheme holds the portfolio of other mutual funds. A certain FoF might invest in a mutual fund scheme that is part of the same mutual fund house or part of another mutual fund house. The portfolio of a FoF scheme is created to suit a variety of investors across various risk profiles and financial goals. The primary aim is to allow investors to receive the opportunity to benefit from the tool of diversification since they get to invest in a slew of mutual fund categories. FoFs can be overseas as well as domestic in nature. With foreign FoFs, the fund manager opts to invest in the units of an offshore mutual fund scheme. The fund manager ensures that the target mutual fund’s risk profile as well as investment philosophy match with the mutual fund’s mandate. The goal of most FoF schemes is to begin the process of wealth creation in the long run.

How Does a Fund of Funds Work?

A Fund of Funds (FoF) is a type of investment fund that is actively managed. This means that a dedicated fund manager is responsible for closely monitoring the investments and making necessary adjustments in response to market conditions. As with other types of mutual funds, the manager oversees all investment choices on behalf of the fund. In selecting which funds to include, the manager takes into account the financial goals and risk tolerance levels of the investors. The primary objective of the fund manager is to assemble the optimal mix of funds that aims to maximise returns while minimising risk for the investors.

Who Is a Fund of Funds Scheme For?

Now that we understand what is a fund of funds in mutual funds schemes, the next question we should address is it. FoF schemes make for a great bet for small investors whose goal is not to take on a high degree of risk. Diversification present in the funds part of the basket enables FoF investors to lower the degree of risk. FoFs also make for a great investment tool when it comes to medium-term investments for investors who have a small number of funds available to invest each month. To add to this, investors with an investment horizon that exceeds five years can also consider investing in FoF schemes.

Types of Funds of Funds in India

There are many different types of fund of funds schemes available to invest in India. Some of these are as follows:

Gold Fund of Funds:

A gold fund of funds scheme will invest in multiple different forms of gold through their basket of mutual funds investments. This includes investing in mutual funds that invest in physical gold, as well as the funds that invest in stocks of gold mining companies.

Multi-Manager Fund of Funds:

A multi-manager fund of funds is one where a basket of professionally managed mutual funds are all invested into and combine to form a single investment portfolio.

Asset Allocation Fund of Funds:

These types of fund of funds invest in a variety of asset classes. They can range from commodities and metals to classic equity-oriented and debt-oriented mutual fund schemes. One can opt for such funds based on their financial goals, and risk profile.

International Fund of Funds:

These are investments in international mutual fund schemes that mainly comprise the shares or bonds in global companies.

What To Consider Before Investing in Fund of Funds Schemes?

When considering investment in Funds of Funds (FoFs), it's important to take into account several key factors:

Goals and Strategies: Comprehend the core goals and strategies of the FoF to ensure they are in line with your financial objectives and level of comfort with risk.
Cost Analysis: Scrutinise the comprehensive cost structure, including the total expense ratio of both the FoF and the constituent funds, recognizing that higher costs can affect net returns.
Historical Results: Review the past performance data of the FoF and its component funds to understand their performance consistency and return generation across various market scenarios.
Variety of Investments: Look into the allocation of assets within the FoF and the range of diversification this provides, taking into account the individual funds and their asset class exposures.
Fund Management Acumen: Investigate the fund manager's proficiency and performance history, as their decision-making significantly influences the fund's success.
Tax Considerations: Be aware of the tax ramifications of FoF investments, such as potential capital gains tax, and how these integrate with your tax planning.
Investment Duration: Match your investment timeline to the FoF’s strategic approach, noting that some FoFs might be more appropriate for certain investment durations, whether short or long.

Pros of Investing in Fund of Funds Schemes

Ease of handling:

With just one net asset value to track in a single portfolio, fund of funds schemes are incredibly easy to track as well as manage.

Tax-friendly:

When you invest in fund of funds schemes with the goal of rebalancing your assets, there is to be no taxation on the capital gains earned from this internal transaction. Henceforth, when your fund of funds are rebalanced such that you get to maintain your desired allocation between debt and equity, no taxation on capital gains will be applied.

Professional Fund Management Services:

Before you opt to venture out in individual mutual funds investments, investing in a fund of funds scheme can enable you to invest in professionally managed mutual fund schemes.

Option for those with limited capital:

A fund of funds scheme allows investors possessing only a limited degree of wealth to participate in diversifying their underlying assets. It would, otherwise, be difficult for such investors to assess underlying assets individually.

Credible Portfolio Managers:

Since the fund of funds schemes require the fund managers’ background to be verified and checked, you can rest assured that your investment is in capable hands.

Cons of Investing in Fund of Funds Schemes

Tax implications:

If you opt to sell your fund of funds mutual funds scheme before 36 months are crossed, short-term capital gains tax will be applied based on your income tax slab. In case you opt to sell your fund of funds scheme after 36 months are crossed, a 20% long-term capital gains tax is levied with indexation.

High-expense ratio:

Just as any mutual fund scheme does, the FoF schemes also incur expenses. However, unlike other mutual fund schemes, there is excessive cost levied on these types of schemes. Besides the administrative and general management fees, there will usually be an added expense for the underlying funds. Although the FoF ratio tends to be just 1% for investors, you are still required to pay this amount on each fund that is owned by the FoF scheme.

Over-diversification:

Since FoF schemes invest in multiple different funds which further invest in a slew of securities, one can potentially own the same securities and stocks through different funds. This ultimately reduces the potential for diversification of the mutual fund scheme.

The Takeaway

Fund of Funds schemes are a great option for those who have limited capital, are looking to instantly diversify their portfolio, and wish to foray into the world of mutual fund investing for the first time. These types of schemes, however, do have their drawbacks in the form of a higher expense ratio and potential over-diversification. It is vital one conduct all of the necessary research so they can make an informed investment. Fund of Funds schemes offer an easy way to diversify your investments, even with limited capital. However, be aware of higher fees and the risk of over-diversification. Ready to invest? Sign up with Angel now to start your mutual fund journey!