Fund of Funds

Fund of Funds (FoF) is a type of mutual fund that offers you the convenience and benefits of investing in multiple funds through a single investment.
Fund of Funds
4 mins
24-June-2024

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.

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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.

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%
  • 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.

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?

Funds of funds (FoFs) differ from traditional mutual funds as they primarily invest in other mutual funds or exchange-traded funds (ETFs) rather than individual stocks or bonds. FoFs offer diversified exposure to various underlying funds, making them a convenient option for investors seeking broader diversification.

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 offer diversification benefits and access to specialized strategies, making them suitable for some investors, but their performance may vary.

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?

FoFs could invest in one mutual fund scheme that invests in stocks, one debt fund scheme that invests in bonds, and one gold fund scheme. It helps you to diversify your investments across different asset classes to earn better returns by minimizing the portfolio risk.

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Disclaimer

Bajaj Finance Limited (“BFL”) is an NBFC offering loans, deposits and third-party wealth management products.

The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

This information should not be relied upon as the sole basis for any investment decisions. Hence, User is advised to independently exercise diligence by verifying complete information, including by consulting independent financial experts, if any, and the investor shall be the sole owner of the decision taken, if any, about suitability of the same.