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.
How Does Fund of Funds Work?
The functioning of a Fund of Fund is relatively straightforward. Investors contribute their funds to the FoF, and the fund manager allocates these funds across various underlying mutual funds. The fund manager's expertise is critical in selecting the mix of funds, aiming to achieve the desired balance between risk and return according to the objective of that FOF. This layered approach allows investors to gain exposure to multiple asset classes and investment strategies without the need for direct management.
Types of Fund of Funds (FOFs)
- 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 (FOFs): 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 (FOFs): 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 (FOFs): 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 (FOFs): 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.
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
- 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.