All investors are different. Many may not be able to digest the tide of equity while the safety of debt might not excite some others. The mutual fund industry has been evolving to cater to all investors through various types of schemes customized to the varied risk profiles of investors. Fund of funds (FoF) is one such scheme that invests its pool of resources in other mutual funds available in the market. How does this help? Why should one look at such an option? Let’s deep-dive into what FoFs are.
This article covers:
- What are fund of funds?
- Popular types of fund of funds
- Advantages of fund of funds
- Disadvantages of fund of funds
What are fund of funds?
Fund of funds is a mutual fund investment scheme wherein the pooled capital of investors is invested in another mutual fund rather than diversifying into equities, bonds or other asset classes. This helps investors create a portfolio of mutual funds instead of direct exposure to stocks, bonds, or other securities. This also means that the underlying investments for an FoF are the units of other mutual fund schemes.
The FoF works in two ways, the fettered way and the unfettered way. A fettered way of investing means that the entire capital of a fund is invested in portfolios managed by the same investment company. In an unfettered way, the investments are made into external funds which different fund managers and fund houses manage.
FoFs can be domestic, as in, invest in domestic mutual funds, or give investors a unique opportunity to get exposure to foreign markets through a foreign FoF! In a foreign FoF, the domestic fund invests its capital in the portfolio of a foreign fund that has exposure to securities native to that country or global assets.
Popular types of fund of funds
Asset allocation funds
This type of fund seeks exposure to funds that consist of multiple investment asset classes, including equity funds, debt funds, commodities funds such as gold funds, and may even have funds with foreign exposure. The diversification this FoF provides is large scale. For the same reason, the risk is substantially low.
Gold FoFs invest in various mutual funds that have exposure to gold securities. Usually, gold funds trade in gold securities or direct investments into gold trading companies. The investment choice depends on the asset management company.
Foreign or international fund of funds
The international fund of funds targets foreign mutual funds and creates a portfolio around foreign investment assets. This has multiple benefits, including geographical diversification and, most importantly, high yield generation in the case of bull runs.
Multi-manager fund of funds
It is one of the most common types of FoF in the Indian market. It comprises multiple asset classes that different fund managers manage. Each fund in the portfolio caters to a specific asset class that a professional fund manager manages. For instance, one manager manages the equity asset class, another manager specialising in commodities will handle commodity funds, etc.
Exchange-traded fund of funds
This FoF comprises various exchange-traded funds in the portfolio. Majorly, investors whose primary financial goal is wealth creation with the facility of high liquidity generally prefer investing in these FoFs.
These apart, there are many more types of FoFs in the global markets such as private equity FoF, hedge fund FoF, investment trusts FoF, etc.
Advantages of fund of funds
As FoF invests in multiple mutual funds, it ensures multi-pronged diversification of portfolio and buffers wealth against sudden economic or political turmoil.
Professionals who manage the FoF portfolio have years of experience in the financial markets. They make investment decisions based on investors’ financial goals and try to beat indexes to generate maximum returns for investors. The portfolio of FoFs is created keeping in mind various risk profiles and strategy aims to achieve the objectives of the fund.
Alleviation of risk and volatility
The volatility in FoF is generally considerably low. Debt funds and G-sec funds offset the volatility and risk associated with equity.
Low resource requirement
Fund managers do all the research required to invest in mutual funds and hedge funds on behalf of clients. Therefore, investors with limited financial resources can easily invest in FoF.
Disadvantages of fund of funds
Given FoFs invest in other funds, there are multiple layers of administration costs involved in managing FoFs. This makes it an expensive fund to invest in.
FoFs are treated as non-equity funds for the purpose of taxation. Even if the fund invests in an equity-oriented scheme, it will still be treated as a debt scheme and taxed accordingly.
Overlap of holdings
When the funds are invested in multiple mutual funds, the chances of having the same securities are high. For instance, if any small-cap company is the same in two of the funds invested, then even a small fluctuation in the price on the downside can affect the portfolio significantly.
Fund of funds offers a unique proposition to investors who are risk-averse and want to minimize their risks. These mutual funds invest in the portfolio of other mutual funds, thereby providing investors with ample diversification across markets and market segments. FoFs are also a popular route through which Indian investors get exposure to foreign markets and international investing. However, they can be expensive to invest in. Reach out to your financial planner to understand if these schemes work for your risk profile.
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