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)
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 (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.
- 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.
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.