A Comprehensive Guide to Fund of Funds

Key Highlights

• A fund of funds (FoF) are mutual funds that invest in units of other mutual funds. They may also invest in foreign mutual funds and exchange-traded funds (ETFs).

• A FoF may have two or more sub-fund managers, indirect investment in securities through other mutual funds, various types like regular mutual funds, hedge funds, etc., and facilitating diversification of investments.

• FoFs provide a wide range of investment opportunities and help in portfolio diversification, professional fund management, constant monitoring of fund performance, suitability for small investors, and tax benefits on capital gains during rebalancing.

• Fund of funds may have high processing costs. This includes management fees of both FoF and the underlying funds. In India, a 10% tax is applicable on dividends exceeding Rs 10 lakh.

What is a Fund of Funds?

A mutual fund scheme that invests in other mutual funds is a fund of funds (FoF). It does not make direct investments in stocks or bonds. Instead, the fund’s portfolio includes other mutual funds. A FoF can invest in mutual funds of the same asset management company (AMC) or in a different fund house. The portfolio aims is curated for different investors with different risk tolerances and financial objectives.

FoF can also invest in international markets. The fund manager buys units of offshore mutual fund schemes. He makes sure that the investing strategy and risk profiles of the target fund align with a domestic fund. Here, the ultimate goal is long-term wealth creation.

How Does a Fund of Funds Work?

Now, that you know the FoF definition, let’s find out how it works. A fund of funds is an actively managed fund. This means that a fund manager constantly monitors the investments. He makes frequent adjustments based on the conditions of the market. Like with other mutual fund schemes, the fund manager takes charge of all investment decisions for the fund.

While considering which funds to invest in, the fund manager considers the investors’ risk tolerance and financial goals, among other things. The fund manager’s job is simple. He must identify the best possible combination of funds for investors. Here, the best combination would provide maximum returns for minimum risk.

Key Features of Fund of Funds

The following are the noteworthy features of funds of funds.

1. A fund of funds is a type of mutual fund: Like any other mutual fund, it pools investors' money and invests it in the markets. A fund house or an asset management company manages it.

2. It involves two or more sub-fund managers: The fund manager of a fund of funds invests the money in two or more other mutual funds. For this reason, s/he may coordinate with the fund managers of those funds.

3. It does not invest directly in the securities: Fund of funds don’t directly invest in a security. This is because it invests in other mutual funds. Its investment in securities is indirectly carried out through other mutual funds.

4. It can be of different types: The sub-funds could be regular mutual funds, hedge funds, private equity funds, or investment trusts. The fund of funds may be ‘fettered’, which means that it invests in funds of the same company. Or it may be ‘unfettered’. In this case, the fund will also invest in funds from other companies.

5. It facilitates diversification of investments: A fund of funds is a good option for investors who wish to diversify their mutual fund investments. The fund allows investments in multiple fund types.

6. It is suitable for investors with low-risk tolerance: You could take this route if you are a small investor with a low-risk appetite. The diversification of such funds minimises the market risks that are normally associated with mutual funds.

7. Investors have to pay handling fees: The fee includes handling charges for all the underlying funds as well. So, you must consider the associated fees and taxes when considering investing in a fund of funds.

Advantages of Fund of Funds

Here are some of the advantages of fund of funds.

• More investment opportunities: A fund of funds brings you access to mutual funds that are not readily available for retail investment.

• Better diversification: One big advantage is that the investments are diversified. This provides lower risk and higher returns.

• Fund management by professionals: A fund of funds is a professionally managed mutual fund scheme. Further, it invests in other mutual funds, managed by professional fund managers. Hence, all investment decisions are weighed and analysed thoroughly by experts.

• Constant monitoring: Fund managers track the fund’s performance constantly. Hence, these funds are better equipped to handle the volatility of the market.

• Suitable for small investors: An investor with limited cash flow significantly benefits. He can develop a diversified portfolio even by investing a small amount.

• Tax benefits: Such investments are also tax-friendly. For example, no tax is levied on the capital gains when a fund of funds is rebalanced.

Disadvantages of Fund of Funds

Following are a few disadvantages of fund of funds.

• High costs: The main disadvantage is the high processing fees. These include the management fees charged by the fund of funds and those of the underlying funds. This may affect the overall returns on fund of funds investments.

• Tax on dividends: Dividends higher than Rs 10 lakh attract a tax of 10%.

• Diversification is not guaranteed: The fund of funds invests in various other funds. Sometimes, one or more of these funds invest in the same stocks and securities. In this case, the investments will not be properly diversified.

Conclusion

A fund of funds offers easy entry into the world of investments. They do not invest in stocks or other securities. Rather, they invest in other mutual funds. So, they offer several investment opportunities and allow portfolio diversification. Moreover, they are managed by professional fund managers. However, the processing fees are quite high. In addition, you must pay tax on dividends if the overall value is above Rs. 10 lakh. Therefore, you should first assess a fund before investing. Understand its investment strategy and the associated costs. Remember to consider your investment goals, risk appetite, and time frame for investment.