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What is Fund of Funds?
The fund of funds (FOF) is a mutual fund scheme that offers investments in additional mutual fund schemes. The fund of funds is the investment in other mutual fund ventures, which has a close resemblance to how funds invest in securities and bonds. So, this mutual fund scheme can invest in debt and equity, depending on your investment target. Let’s know in depth what Funds of Funds are.
What is a Fund of Funds?
The fund of funds is a mutual fund that uses its resource base to invest in various forms of mutual funds present on the market. Alternatively, investment in hedge funds may also be made through this mutual fund.
Mutual Funds have portfolios with different degrees of risk, based on the manager's key objective. The FOF can be both domestic and overseas. The investment manager participates in units of overseas mutual fund schemes in the case of international FOF. He/she makes sure the investment strategy and risk tolerance of the target portfolio fits that of the mandate of the fund. In the long term, the key aim is to deploy money.
These mutual funds may, at the discretion of the wealth management firm, be used to invest in both domestic and foreign funds. The critical aspect of these mutual funds is that they are maintained by experienced portfolio managers who are highly trained in portfolio investment. To a certain point, this guarantees correct business forecasts, reducing the risk of failure.
It is quite obvious to wonder why you would invest in other schemes in a mutual fund scheme? The response is simple: when there are successful mutual fund schemes with steady results that have already proved their value, what is the point of direct investment in equity and stock? Why not participate in these services with an established track record? That is the fundamental reasoning behind these systems.
Types of Fund of Funds: A Broad Classification
The fund of funds consists of two groups, one focused on the domestic market and the other on the global market. There are three forms of FOFs available: those that invest in international markets, debt instruments, and equities. Almost all the asset groups cover these FOFs. For e.g., FOF invests in gold, debt funds, or equity funds for asset allocation. Overseas-focused FOFs participate in the scheme in international markets that are invested in bonds and in the shares of companies based in that particular area. The following make it to the top list in the country:
Asset allocation funds
These funds consist of a large pool of assets, including stocks, debt instruments, precious metals, etc. This supports asset allocation funds to achieve higher returns for the investors at a reduced degree of risk guaranteed by the reasonably stable securities contained in the portfolio.
Gold funds
Gold funds generally invest in different mutual funds schemes that are primarily dealing with gold securities. Depending on the wealth management firm involved, assets belonging to this group may have a portfolio of mutual funds or gold trading firms themselves.
International FOF
The international Fund of Funds invests in the mutual funds that operate in foreign countries. These funds help the investors, via the top-performing stocks and bonds in the respective region, to theoretically achieve greater returns.
Multi-manager FOF
This is the most common form of mutual fund offered in the market. The asset base of a multi-manager fund has numerous mutual funds run professionally, many of which have different concentrations in the portfolio. There are normally numerous portfolio managers in a multi-manager Fund of Funds, each concerned with a different asset present in the mutual fund.
ETF fund of funds
The ETF fund of funds, which contains exchange-traded funds in its portfolio, is the country's most common investment instrument. Investing in an ETF through a fund is more open than investing directly in the instrument. However, since they are exchanged like securities in the stock market, ETFs have a marginally higher risk factor associated with them, rendering these funds more vulnerable to market fluctuations.
Pros and Cons of Fund of Funds
| Pros | Cons |
|---|---|
| 1. Higher Diversification Particularly for investors, fund of funds allows a higher degree of diversification because they invest in a variety of schemes that further invest their corpus in several different underlying assets. | 1. Expense ratio Expense ratios for the management of the fund of funds are greater than the ordinary Mutual Funds since they have higher management expenses. Added costs cover, in fact, the choice of the correct asset to invest in, which tends to fluctuate regularly. This cost amounts to a considerable sum and is excluded from the total returns earned by the asset management firm. |
| 2. Low resource requirement An investor with limited financial resources too can invest in top performing fund of funds and reap higher returns. | 2. Tax implications The tax charged on the fund of funds is payable by the investor only after the repayment of the principal sum. However, all short-term and long-term capital gains are entitled to tax reductions, based on the investor's annual revenue and the duration of the investment. |
| 3. Experienced fund managers have due diligence The multi-manager investment schemes are quite diligently managed; the credentials of the different schemes operated by the fund house and its managers are verified. | 3. Diversification Since FOFs invest in various funds, there is a strong possibility that these underlying funds would invest in related stocks and shares. This might then reduce the potential for diversification. If there is a balance in the holdings, diversification does not add benefit to the investment. Frequent vigilance is therefore needed to preserve the equilibrium. Otherwise, the FOF will have so much exposure to the same assets. |
| 4. SIP (Systematic Investment Plan) Much like most mutual funds, SIP modes of investing are offered by many funds of funds. By way of SIP, investors are able to take advantage of compounding, rupee cost averaging, etc | 4. Not Transparent The fund of funds invests in various mutual funds and, for investors, it can be challenging to maintain track of the pool of assets of any of these mutual funds. |
How to Invest?
There are two ways in which an individual can invest in a fund of funds:
1. Online
You can invest seamlessly online in the Fund of Funds through online platforms (such as sipfund.com)
2. Offline
This conventional investment mode requires an investor to fill out a form and submit it to your Independent Financial Advisor.
Fees and Charges Pertaining to FOF
FOFs have a greater expense ratio. FOFs charge maintenance fees for the service given for the allocation of assets. Compared to a standard investment, the fee is nominally high. A fund's fiscal report explicitly lays out all the relevant fees incurred through the life of the fund. When investing, it is important to take into account the overall cost, since it has a significant effect on the return on investment.
Are you the person looking for FOFs?
Maximizing returns by investing in a diverse portfolio with low risk is the key goal of Fund of Funds. Such investment can be preferred by people with access to a limited pool of financial capital, which they can spare for a longer period of time. As the portfolio of such funds consists of different types of mutual funds, access to high-value funds is also assured. Ideally, investors with comparatively less capital and low liquidity requirements can opt to invest in the market's top fund of funds. This encourages them, at minimum expense, to gain optimum returns.
The mutual fund industry in India has been consistently lobbying for a more favorable tax status as there is a tax difference considering to FOFs. For instance, even if a FOF has exposure in equity funds, for tax purpose one’s investment in FOF will still be considered as non-equity fund. That implies short term will be 3 years and investors have to pay STCG at the peak rate. Similarly, LTCG will be taxed at 20% after considering the benefit of indexation. This puts the FOF at a disadvantage over equity funds. Also, the dividend distribution tax (DDT) is imposed at two levels and that also adds to the cost. This kind of unfavorable tax treatment is one of the key reasons why the FOFs have not become much popular in India.
Given below is the list of some of the top performing Fund of Funds
| Scheme Name | 1 Year Return | 3 Year Return | 5 Year Return |
|---|---|---|---|
| Edelweiss Greater China Equity Off-shore Fund - Fund of Funds | 45% | 86% | 121% |
| PGIM India Global Equity Opportunities Fund - Fund of Funds | 40% | 83% | 112% |
| Motilal Oswal Nasdaq 100 Fund of Fund | 27% | NA | NA |
| ICICI Prudential Asset Allocator Fund (FOF) | 20% | 25% | 38% |
| Kotak Asset Allocator Fund - Fund of Funds | 23% | 34% | 45% |
| Aditya Birla Sun Life Asset Allocator - Fund of Funds | 20% | 26% | 36% |
Tips for Investors
Often, FOFs offer a strong diversification for an investor with a single fund. However, it is still advisable to consider the pros and cons before investing. First, to determine the performance of the fund manager, select the fund with the most qualified manager. Second, ensure that your investment goal is compatible with that of the Fund. Third, depending on your risk appetite, investment horizon, and tax consequences, select the fund that better suits your profile. At last, take into consideration the high expense ratio of the funds.
The Bottom Line
Both merits and demerits exist for FOFs, and investors must determine whether or not this asset class is a suitable addition to their portfolios. If you're an amateur investor with little experience and little resources, the Fund of Funds may be a perfect investment option. FOFs are exposed to market uncertainties, much like other mutual fund schemes. Therefore, to make good investing decisions, it is paramount that you know the market risk and the various investment strategies.