Fund of Funds (FoFs)

As Ravi and Priya continue to learn about mutual funds investing, the convenience and fascination of investing in FoFs catch their eye. Priya feels explicitly interested in the concept of a single fund that offers access to multiple kinds of investments because her idea has been to seek a simple way toward diversification without having many funds to manage.

They think about how FoFs could fit into their growing investment portfolio, while Ravi questions how costs and underlying fund selections might harm or help their returns.

One of the biggest advantages of FoFs is diversification. Instead of relying solely on one or two sources, your money is spread across several. This helps reduce the risk because you’re not putting all your eggs in one basket. If one fund performs poorly, the others might do better, helping to balance things out. For example, if you invest in a FoF that includes equity, debt, and international funds, you’re getting exposure to a variety of markets and sectors. This kind of diversity can cushion your portfolio during tough times.

The other advantage is that FoFs are a very convenient means of entry. They are a one-stop for those wanting exposure to all sorts of funds with minimal time taken to pick them. This saves you effort from managing multiple investments since a good fund manager picks and selects the necessary funds inside the FoF. This makes it a good option for beginners or those with little time to track the markets.

But here's the thing: because FoFs invest in other funds, you're paying the fees for the FoF itself and its underlying funds. This makes the overall cost of investing in a FoF higher than investing in a single fund. If the fees become too high, they will eat into your return, so carefully look at the expense ratios.

The other one is that FoFs need to be more flexible in investing, unlike when the funds were directly invested in the fund house. For instance, you can't add or remove any particular fund in its portfolio if you wish; that decision is left to the fund manager. This might be a drawback for those who like controlling their investments. But if that is okay with you, this will have the advantage of being an arms-length investment.

Let us remember that FoFs can also be actively managed or passively managed. When a FoF is described as actively managed, the fund manager picks his targets based on his discretion and research. The selection strategy must aim to outperform the market for the funds that decide to become top performers.

In return, a passively managed fund would mimic the return of a market index-invested fund benchmarking on an index, such as the S&P 500 or Nifty 50. The trade-off is that these passively managed funds may not outperform the market, while actively managed funds would strive for this, though charges usually are lower.

You should carefully review the underlying funds a FoF holds if you're considering investing in one. Understanding the overall performance of the FoF is not enough; you also need to understand where your money is going. If the FoF invests heavily in a single market or industry, you may be more vulnerable to risk than you realise. Verifying that the fund manager is selecting wisely for your portfolio is crucial.

Conclusion:

After learning about Fund of Funds (FoFs), Ravi and Priya appreciate how this approach simplifies diversification and provides exposure to multiple markets and strategies. However, they also understand the importance of monitoring costs and evaluating the underlying funds carefully.

Next, we’ll discuss Dividend vs. Growth options and how to choose the right one for your investment strategy.