Fund of Funds

A Fund of Funds (FOF) is an investment vehicle that allocates capital into a diversified portfolio of other funds, rather than directly purchasing individual stocks, bonds, or securities, providing investors with broader diversification and professional fund management expertise.
EXPLORE FUNDS
What is fund of funds
EXPLORE FUNDS
4 mins
30-December-2024

Fund of Funds (FOF) is an innovative investment strategy allowing investors to allocate their money into a collection of other funds rather than directly purchasing individual stocks, bonds, or securities. FOF schemes typically focus on investing in units of other mutual funds. This approach helps create a diversified portfolio, combining various securities like equities, debt instruments, or hybrid funds into a single investment vehicle. By pooling resources across multiple funds, FOFs provide broad exposure, professional fund management, and risk diversification, making them an attractive choice for investors seeking comprehensive portfolio management without directly engaging in individual securities.

Diversification has long been hailed as a prudent investment strategy. Enter Fund of Funds (FoFs), a financial instrument that takes diversification to the next level. By offering exposure to a collection of mutual funds, FoFs have gained traction as an efficient way to manage risk and enhance potential returns. In this article, we will understand Fund of Funds, their meaning, types, advantages, limitations, and suitability for different investors.

What is a Fund of Funds (FoF)?

A Fund of Funds, as the name suggests, is an investment vehicle that pools capital from investors to invest in a diversified portfolio of other mutual funds. It is a strategy that offers a second layer of diversification. Instead of directly investing in individual stocks or bonds, investors place their money in a FoF, which, in turn, invests in a selection of other funds.

Portfolio managers leverage their expertise to select funds with strong past performance and profitability, aiming to maximise returns for Fund of Funds (FOF) investors. With skilled management, FOFs can achieve above-average returns. FOFs are categorised as fettered or unfettered. A fettered FOF invests exclusively in funds managed by the same company, while unfettered FOFs enjoy the flexibility to invest in funds from various companies. This classification determines the investment scope, offering either a focused approach or broader diversification. The choice between fettered and unfettered FOFs depends on the investor’s preferences for diversification and the managing company’s expertise.

How Does Fund of Funds Work?

A Fund of Funds (FOF) operates through a layered investment approach that simplifies portfolio diversification for investors. When individuals invest in a FOF, their contributions are pooled together and managed by a professional fund manager. This manager allocates the collective funds across a carefully curated selection of underlying mutual funds, rather than directly investing in stocks, bonds, or other securities.

The fund manager plays a pivotal role in this process, utilising their expertise to evaluate and select a mix of funds aligned with the FOF’s investment objective. The primary goal is to achieve an optimal balance between risk and return. By investing in multiple mutual funds, FOFs offer access to a wide range of asset classes, investment styles, and market sectors, providing comprehensive diversification within a single portfolio.

This structure is particularly appealing to investors seeking a hands-off approach to asset management. It eliminates the complexity of researching individual securities or managing multiple mutual funds independently. Instead, investors benefit from the layered expertise of the underlying funds’ managers and the FOF manager.

Additionally, FOFs cater to varying risk appetites and financial goals, offering options that range from conservative to aggressive strategies. This makes them an ideal choice for those looking to simplify their investment journey while maintaining exposure to diverse markets and strategies, all under a single fund. In essence, FOFs provide a seamless path to diversification and professional management without the need for direct oversight by the investor.

Types of Fund of Funds (FOFs)

Fund of Funds (FOFs) encompass various types tailored to different investment objectives. Here’s a brief description about some of them:

Asset allocator or multi-asset funds

Asset allocator or multi-asset fund of funds aim to diversify across various asset classes, such as equities, bonds, real estate, and commodities. These FOFs focus on allocating funds strategically to achieve a balanced portfolio that can adapt to different market conditions. The goal is to optimize returns while managing risk by spreading investments across different types of assets.

International fund of funds

International Fund of Funds invest in mutual funds or ETFs that are based in foreign markets. These FOFs provide investors with exposure to international stocks, bonds, or other assets. This type of FOF is suitable for those seeking global diversification and access to opportunities beyond their domestic market.

ETF-based fund of funds

These are the Fund of Funds that incorporate exchange-traded funds (ETFs) within their portfolio. Opting to invest in an ETF via a fund of funds offers enhanced accessibility compared to a direct investment in this financial instrument. The distinction arises from the fact that investing in ETFs mandates the possession of a Demat and trading account, a requirement not applicable when investing in ETF fund of funds. It is important to note that ETFs carry a marginally elevated level of risk, primarily due to their trading nature akin to shares within the stock market. Consequently, these fund of funds incorporating ETFs are more exposed to market volatility.

Gold fund of funds

Gold Fund of Funds invest in funds that track the performance of gold or related assets. These FOFs provide exposure to the price movement of gold without physically owning the metal. Gold FOFs can be a way to diversify a portfolio and hedge against currency fluctuations and economic uncertainty.

Multi-manager fund of funds

This is the most prevalent kind of Fund of Funds in the market. Such funds consist of different professionally managed Mutual Funds in their portfolio, each with distinct holdings. A multi-manager Fund of Funds typically has several portfolio managers, each responsible for a specific asset within the Mutual Fund.

Hedge fund of funds

These funds invest in a basket of Hedge Funds rather than directly in stocks or bonds. By accessing alternative investment strategies employed by Hedge Funds, they seek higher returns or risk mitigation.

Single strategy fund of funds

These funds focus on a specific investment approach, such as growth-oriented, income, or value-oriented strategies. By investing in various funds with a singular approach, they aim to capture returns from that strategy.

Regional or geographic fund of funds

These funds target investments within a specific geographic region or country, like an Asia-Pacific FOF concentrating on the region's funds. They offer exposure to regional market opportunities.

Sector-specific fund of funds

These funds concentrate on a particular sector or industry, like technology, healthcare, or energy. By investing in sector-specific funds, they aim to capitalise on the growth potential within that sector.

Passive fund of funds

These funds invest in a portfolio of Index Funds or Exchange Traded Funds (ETFs) to mirror the performance of a specific market index or benchmark. Their goal is to replicate the returns of the tracked index.

Active fund of funds

Unlike passive FOFs, these actively managed funds involve fund managers actively selecting and adjusting underlying funds. They aim to outperform the market or a specific benchmark through strategic investment decisions.

Each type of Fund of Funds has its own unique features and benefits, catering to different investor preferences and objectives. Before investing in any of these FOFs, it's essential to understand their investment strategy, associated risks, historical performance, and alignment with your overall financial goals.

Each type of Fund of Funds has its own unique features and benefits, catering to different investor preferences and objectives. Before investing in any of these FOFs, it's essential to understand their investment strategy, associated risks, historical performance, and alignment with your overall financial goals.

Advantages of Investing in Fund of Funds

Here are some advantages of investing in Fund of Funds (FOFs)

  • Diversification: FoFs offer an extra layer of diversification by investing in a range of funds, reducing the impact of poor performance in any single fund.
  • Professional Management: FoFs are managed by experienced professionals who select and manage the underlying funds, saving investors the hassle of continuous monitoring.
  • Convenience: FoFs simplify investment decisions by providing exposure to multiple funds through a single investment.
  • Accessing diverse strategies: FOFs offer exposure to a range of investment strategies, asset classes, and fund managers not readily available to individual investors. This grants investors access to various investment opportunities through a single investment vehicle.
  • Mitigating risk: FOFs can potentially decrease the risk linked with individual fund selection. By investing in a collection of funds, FOFs may help alleviate the impact of underperforming funds in the portfolio, thereby reducing overall investment risk.
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Limitations of Fund of Funds

Here are some limitations of investing in Fund of Funds:

Fees: FoFs can come with higher expense ratios due to the fees charged by both the FoF and the underlying funds.

Lack of Control: Investors relinquish control over individual fund selection, which might not align with their personal preferences.

Overlapping Holdings: There's a possibility of overlapping holdings between the FoF and the underlying funds, leading to unintended concentration.

Fund of Funds provide investors with an approach to diversification, combining the benefits of multiple funds within a single investment vehicle. While they offer convenience, access to expertise, and risk management, it's essential for investors to weigh the advantages against the potential drawbacks, such as fees and lack of control.

Who Should Invest in FOFs?

  • Diversified Investments: FoFs appeal to investors seeking diversification and exposure to various fund managers within a single investment vehicle.
  • Moderate Risk Appetite: FoFs allocate a significant portion of funds to equities, making them suitable for individuals with a moderate risk tolerance.
  • New investors: FoFs can be an excellent starting point for new investors, allowing them to learn about mutual fund performance and gain confidence for future direct investments in mutual funds and equities.

How to invest in FOFs?

Investing in a FoF offers both online and offline options. Online investments can be made through SIPs or lump sum investments via trustworthy platforms like Bajaj Finserv.  Alternatively, investors can opt for the offline route by completing a physical application form and submitting it either at the nearest AMC branch or through a broker.

However, as there are numerous FOFs available in the market, it is important to know how to invest in FOFs. Here are the steps to follow to invest in FOFs in India:

  • Research and selection: The first step is to determine your investment goals and risk tolerance, which will help you analyse numerous FOFs available in the market. Evaluate and compare the investment objectives, historical performance, risk profiles, expense ratios, and portfolio composition of FOFs with each other to find the ideal one that aligns with your set investment goals and risk tolerance.
  • Choose an investment platform: Compare various banks or financial institutions based on their cost structure and features to choose the best investment platform for investing in FOFs.
  • Open an account: Once you have chosen the investment platform, start with the process of opening an investment account. The account opening process will include filling out a form and providing documents for KYC.
  • Fund selection: Based on your analysis and research, choose the particular FOFs you want to invest in. You can do this by logging in to your investment account.
  • Investment amount: Once you have selected the FOF, determine the amount you want to invest. Each FOF scheme has a different minimum amount requirement. Analyse the requirements and ensure that you fulfil the minimum amount criteria.
  • Place your order: Use your investment amount and the included features to place an order to invest your determined investment amount in the FOF units. While placing the order, you will have to specify the number of units you want to buy in the specific FOFs and make the relevant payment.

Taxation of Fund of Funds

Mutual funds, including Fund of Funds (FoFs), are categorised into equity-oriented and other than equity-oriented funds for tax purposes. To be classified as equity-oriented, FoFs must invest at least 90% in ETFs, which further invest at least 90% in Indian company shares. Otherwise, they are considered 'other than equity-oriented' schemes, subject to varying tax rates based on holding periods.

For equity-oriented funds

  • Short-term capital gains (STCG) within 12 months are taxed at 15% 20%
  • Long-term gains (LTCG) exceeding 12 months are taxed at 10% after a Rs. 1 lakh exemption.

For other than equity-oriented funds

  • STCG within 36 months incurs regular tax rates
  • LTCG exceeding 36 months is taxed at 20% with indexation.

It is advised to stay up to date on the latest income tax rules on a regular basis, read Income Tax slabs for FY 2024-25 for more information.

Limitations of Fund of Funds

Here are some limitations of investing in Fund of Funds:

  • Fees: FoFs can come with higher expense ratios due to the fees charged by both the FoF and the underlying funds.
  • Lack of Control: Investors relinquish control over individual fund selection, which might not align with their personal preferences.
  • Overlapping Holdings: There's a possibility of overlapping holdings between the FoF and the underlying funds, leading to unintended concentration

Things to remember before investing in FOF

When investing in Funds of Funds (FoFs), investors should consider the following factors:

  • Objective and Strategy: Understand the primary objective and investment strategy of the FoF to ensure it aligns with your financial goals and risk tolerance.
  • Expense Ratio: Evaluate the total expense ratio (TER) of the FoF, including both the FoF's expenses and the underlying funds' expenses, as high expenses can impact overall returns.
  • Performance History: Analyze the historical performance of the FoF and its underlying funds to gauge their consistency and ability to achieve returns over different market conditions.
  • Diversification: Assess the FoF's asset allocation and the diversification benefits it offers, considering the underlying funds and their exposure to different asset classes.
  • Risk Profile: Evaluate the risk profile of the FoF, taking into account the risk levels associated with its underlying funds and whether they align with your risk tolerance.
  • Manager's Expertise: Research the expertise and track record of the fund manager managing the FoF, as the manager's decisions can significantly impact the fund's performance.
  • Tax Implications: Understand the tax implications of investing in the FoF, including capital gains tax, and consider how it fits into your overall tax planning strategy.
  • Market Conditions: Consider the prevailing market conditions and economic outlook, as these factors can influence the performance of the FoF and its underlying funds.
  • Regulatory Environment: Stay informed about any changes in regulations that may impact the FoF, ensuring compliance with regulatory requirements.
  • Investment Horizon: Align your investment horizon with the FoF's strategy, as certain FoFs may be better suited for short-term or long-term investment objectives.

Should you invest in a fund of funds?

Investing in fund of funds can prove to be highly beneficial as they primarily invest in mutual fund units that are already low-risk and offer effective diversification. Diversification helps spread risk across various asset classes and sectors, potentially reducing the impact of poor performance on any single investment. FOFs are managed by portfolio experts who handpick the fund units based on the FOFs investment goals and risk profile, helping investors choose funds easily based on their personal investment goals and risk tolerance.

The fund manager also regularly monitors and rebalances the portfolio to align with the fund’s investment objectives and market conditions. Furthermore, FOFs can also provide exposure to specific asset classes, such as foreign companies, which investors otherwise overlook for direct individual investments. However, you must analyse the FOFs to avoid portfolio overlaps with assets in your personal portfolio before investing.

Future trends in fund of funds

Future trends in Fund of Funds (FOFs) are shaped by evolving investor preferences and market dynamics. A key trend is the growing focus on thematic and sector-specific FOFs, which allow investors to target emerging industries such as technology, green energy, and healthcare. Additionally, environmental, social, and governance (ESG) criteria are increasingly influencing FOF offerings, aligning investments with sustainable practices.

Technological advancements, such as AI-driven portfolio management, are expected to optimise fund selection and performance monitoring. Global diversification will also gain prominence, with FOFs providing exposure to international markets for enhanced risk-adjusted returns.

Moreover, there is a rising demand for low-cost FOFs that leverage passively managed funds, like index and exchange-traded funds (ETFs), reducing expenses while maintaining broad diversification. Personalisation through customisable FOFs catering to individual risk appetites and financial goals is another emerging trend.

These developments position FOFs as versatile, accessible, and innovative investment vehicles for future-focused investors.

Multi-Strategy Funds (MSFs) vs FOFs

In recent years, the hedge fund industry has witnessed a surge in multi-strategy funds (MSFs), a term that has gained widespread adoption. Given the historical association of funds of funds (FOFs) with excessive fees, MSFs were initially perceived by some as a repackaging of an older concept. However, while this may be true in certain instances, there are distinct differences between these two fund structures.

A multi-strategy fund is managed by a single individual responsible for overseeing multiple investment strategies. Contrary to the misconception of a generalist approach, most multi-strategy fund managers possess deep expertise in several areas or employ teams of specialists. While the manager may have a background in a specific strategy, they often incorporate additional strategies to enhance the fund's capacity or capitalize on emerging opportunities.

MSFs are well-suited for investors seeking a diversified portfolio under a single manager, potentially lower fees, and the ability to adapt to changing market conditions swiftly. However, concerns may arise regarding the manager's ability to effectively manage multiple strategies simultaneously. Consequently, FOFs may be more appealing to investors who prioritize diversified exposure across multiple managers and are willing to accept potentially higher fees.

Key takeaways

  • Diversification: FOFs provide an advanced approach to diversify investments across multiple fund types, enhancing portfolio stability.
  • Expertise: Investors benefit from the combined expertise of FOF managers and underlying fund managers, ensuring professional oversight.
  • Costs: FOFs may have higher expense ratios due to layered management fees, which investors should consider.
  • Risk-return profile: Compared to single-fund investments, FOFs generally offer a balanced risk-return profile, appealing to risk-conscious investors.

Conclusion

FoFs can be a valuable addition to a well-rounded investment portfolio, especially for those seeking a balanced and diversified approach to wealth accumulation. As with any investment decision, careful consideration of personal financial goals and risk tolerance is crucial.

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Frequently asked questions

How do funds of funds mutual funds differ from traditional mutual funds?

Unlike traditional mutual funds that directly invest in stocks or bonds, Funds of Funds (FoFs) invest in other mutual funds or ETFs. This approach offers diversified exposure to various funds, providing investors with a simpler way to access multiple asset classes and strategies.

What types of assets do funds of funds typically invest in?

Funds of funds typically invest in a mix of assets, which can include equity mutual funds, debt mutual funds, international funds, and even other FoFs. The specific asset classes and allocations may vary based on the FoF's investment objectives and strategy.

What are the key considerations when evaluating funds of funds?

When evaluating FoFs, it's crucial to assess factors such as the fund's expense ratio, performance track record, the expertise of the fund manager, the asset allocation strategy, and the associated risks. Additionally, investors should align the FoF's objectives with their own investment goals and risk tolerance to ensure it complements their overall portfolio.

What is the difference between MF and FOF?

Mutual funds pool money from investors to invest in a variety of assets, while fund of funds (FOF) invest in a portfolio of other mutual funds rather than directly in securities.

Is fund of funds a good investment?

FoFs can be a good choice for investors seeking diversification and access to professional management. However, their suitability depends on individual goals and risk tolerance, as performance can vary based on the underlying funds and market conditions.

Who manages the fund of funds?

FOFs are managed by fund managers or investment professionals who allocate assets across different underlying funds based on the FOF's investment objectives.

What is the tax on funds of funds?

Tax on FOFs depends on their classification as equity-oriented or other than equity-oriented, with varying tax rates for short-term and long-term gains.

What is another name for fund of funds?

Another term for FOFs is multi-manager funds, reflecting their structure of investing in multiple underlying funds managed by different managers.

What is the difference between FoF and MF?

These schemes offer the investor an opportunity to diversify risk by spreading investments across multiple funds. The underlying investments for a FoF are the units of other mutual fund schemes either from the same mutual fund or other mutual fund houses.

Which is better, ETF or FOF?

ETF stands for Exchange Traded Funds. ETFs are considered less risky and the returns that are generated are more or less equal their underlying benchmark.
FoF is Fund of Funds which are considered risker than ETFs.

What are the benefits of fund of funds?

Fund of Funds have multiple benefits such as helping investors diversify their investments across various underlying funds or asset classes. Diversification of funds allows investors to bridge any kind of losses they might have to face, had their funds being invested in the open market.

What is the fee for fund of funds?

Fund of Funds usually has a fee of 1 and 5. This means 1% is the management fee of the investment that you make and 5% is performance fee on any gains that you make. This fee is additional to what you invest in FoF.

What is a example of a fund of funds?

A Fund of Funds (FoF) might invest in a combination of schemes, such as a mutual fund focusing on equities, a debt fund investing in bonds, and a gold fund. This structure diversifies investments across asset classes, reducing portfolio risk while aiming for improved returns.

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