Fund Of Funds (Fofs): Meaning, Types, Advantages, And Limitations

Explore Fund of Funds (FoFs) - their meaning, types, advantages, and limitations.
Fund Of Funds
4 mins
12 December 2023

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.

Limitations of 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.

Things to Consider as an Investor

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.