What is a Fund of Funds (FoF) scheme?
A scheme that invests in other mutual fund schemes
The best part of Fund of Funds is the diversification of funds
You know how mutual funds invest in stocks and bonds. Similar to that, certain funds invest in other mutual funds or hedge funds available in the market utilizing their pool of resources. These mutual funds are called Fund of Funds schemes. Investment in this type of fund is often referred to as a multi-manager investment. The aim is to achieve broad diversification with minimal risk.
What is the Fund of Funds (FoF) scheme?
A scheme that invests in other mutual fund schemes of the same fund house or another fund house is known as Fund of Funds. Instead of investing directly in equities or bonds, the fund manager holds other mutual funds in his portfolio. The portfolio is designed in such a way that it will suit investors across risk profiles and financial goals. The investors can avail the opportunity to benefit from the diversification as an investment is spread across numerous fund categories, and risk is reduced. The ultimate objective of the scheme is to create wealth over the long run.
The FoF can be domestic as well as overseas as per the discretion of the asset management company. It allows increased diversification of the portfolio. The foreign FoF invests in units of offshore mutual fund schemes.
Who should invest in Fund of Funds scheme?
The best part of Fund of Funds is the diversification of funds helps to reduce the risk. Therefore it is a good option for small investors who do not wish to take higher risks. Ideally, investors having relatively fewer resources and low liquidity needs and having an investment horizon of five years or more may opt to invest in the top Fund of Funds available in the market. It enables investors to earn maximum returns at minimal risk.
Types of Fund of Funds Schemes
There are primarily two types of FOF. It may be fettered that invests only in portfolios managed by one investment company, or it may be unfettered, by investing in external funds controlled by other managers from other companies.
Favourite Fund of Funds Schemes in India
Asset Allocation Funds
Asset allocation funds are those FoF that invest in a varied class of assets, including equity and debt instruments, and other asset classes like gold, other precious metals, and commodities.
Gold funds invest in mutual funds trading in various forms of gold, including physical gold. The investment is also made in stocks of gold mining companies.
Foreign or International Fund of Funds
International FoFs include investments in bonds and shares of global companies. This international Fund of Funds targets mutual funds that are operating in foreign countries.
Multi-Manager Fund of Funds
A multi-manager FoF consists of a single portfolio managed by multiple professionals, each handling a specific asset present in the Mutual Fund.
ETF Fund of Funds
Fund of Funds having exchange-traded funds in their portfolio is quite popular in the country. Investing in an ETF through Fund of funds is easier than directly investing in this instrument as ETFs require a Demat trading account. But investing in the ETF Fund of Funds has no such limitations. However, this fund is more susceptible to market volatility and associated with high risks.
Advantages of Investing in Fund of Funds Scheme
Investing in a FoF allows a two-layer diversity that reduces market risks. First, there is a diverse set of mutual fund schemes, and secondly, the financed schemes again invest in diverse assets like equity and debt securities.
Investment in a diverse set of schemes of different asset classes lowers down the risk from a specific asset class, such as market risk from equity investment or credit risk & interest rate risk from debt investment.
Professional Fund Management
Highly trained, professional portfolio managers maintain FoF. Instead of investing individually, if you want to invest in professionally managed funds, the Fund of Funds will be ideal to ensure accurate market predictions to a certain extent and minimizing the loss.
When your Fund of Funds is rebalanced to maintain asset allocation between debt and equity, there will be no tax on capital gains as that will be considered as an internal transaction.
Opportunity for investors with limited capital
Fund of Funds allows investors with limited wealth to invest in diversified assets. Otherwise, it would not be possible for such investors to access these assets individually.
Disadvantages of Investing in Fund of Funds Scheme
High Expense Ratio
Fund of Funds tends to have high expense ratios compared to regular mutual funds. As these funds invest in multiple mutual fund schemes, which have their individual expense ratios, the expense ratio becomes high due to the cumulative expense ratio of the underlying funds. The FoF expense ratio is just 1%, but as an investor, you have to pay this amount on every Fund that the FoF owns.
If the holdings sold before 36 months, the short-term capital gain tax would apply to the income of the investor according to the income tax slab. And if the units are sold after 36 months, a long-term capital gain tax of 20% with indexation is applicable.
Too Much Diversification
The funds in which Fund of Funds invests, further invest in several securities. This over-diversification may end up in owning the same stocks and securities through different funds. It reduces the potential for diversification to minimize market risk.
FoF allows easy access to high-value funds, which is otherwise beyond the reach of the investors with limited resources. Before making any investment decision, you must always study the pros and cons of a scheme along with transactional timelines, tax implications. Also, let your advisor know your risk tolerance and objective goals, among other things, to guide you properly.
That’s why Comparte Investment team asks do you have “Nivesh Ki Aadat”.