Fund of Funds (FoF) Explained – Meaning, Types and Benefits
5 October 2022
Fund of Funds or FoF is a mutual fund that invests in units of other mutual funds. This type of mutual fund gives you exposure to multiple funds through a single fund. It’s not necessary that the underlying funds, where the scheme invests, are managed by the same Asset Management Company (AMC) that is managing FoF.
Still confused? Let us simplify Fund of Funds for you. Read on!
What is a Fund of Fund?
Let’s say you are planning to buy appliances for your home. Wouldn’t it be easier for you to buy all the appliances from a single store/website compared to multiple purchases through multiple sites? A Fund of Fund somewhat works with a similar principle.
An FoF gives you the convenience to invest in multiple mutual fund schemes with different characteristics, risk and return profile. This gives you the option to diversify your investment portfolio, where you get to enjoy the benefits of multiple funds through a single fund.
Since an FoF invests in units of different mutual funds schemes that may be managed by different fund managers/AMC, fund of fund is also known as multi-manager investment.
How do Fund of Funds Work?
Fund of Funds facilitates asset allocation across various fund categories. As a result, it creates a diverse set of investments within one portfolio.
Fund of Funds could be either fettered or unfettered, meaning the fund manager could invest in funds managed by the same fund house as its own or in funds not managed by the same fund house.
An FoF aims to minimise the risk involved while diversifying the portfolio as much as possible.
5 Types of Fund of Funds
The best fund of funds schemes includes the following categories:
1. Gold Funds
Investment in various mutual funds, mainly trading in gold instruments, are called gold funds. Depending on the asset management company, this type of fund of funds may have a portfolio of schemes or gold trading entities themselves.
2. Asset Allocation Funds
These schemes comprise a diverse investment pool− with securities consisting of precious metals, debt instruments and equity. These funds draw high returns through top-performing security and guarantee lower risks because of the presence of stable instruments.
An FoF mutual fund having a portfolio of exchange-traded funds is a common investment tool in India. Investing in ETFs via fund of funds is more approachable than direct investments in these tools. This is because exchange-traded schemes need a Demat account, whereas investments in ETFs through FoF require no such obligations.
4. Multi-manager Fund of Funds
This is the most common FoF available in the stock market. The asset base includes professionally managed funds with different portfolio concentrations. These schemes primarily have multiple managers, each handling a particular asset present in the fund of mutual funds.
5. International FoFs
These FoFs target mutual funds present in foreign countries. These schemes fetch higher returns through top-performing bonds and stocks of the concerned country.
FoFs allocate the investment corpus to different mutual fund schemes. Such schemes, in turn, invest in various asset subclasses, thus reducing the risk through portfolio diversification.
2. Access to Various Investment Opportunities
By investing in such funds, you gain access to debt, gold or even to distinct traits of the same asset class. For example, an FoF providing equity exposure may invest in large cap, mid cap or small cap funds. Like this, “n” numbers of schemes can be put together in a fund of funds, providing investors with the opportunity to experience various flavours.
3. Small Investment Amount
You can start investing in a Fund of Funds scheme with just Rs. 500 only to reap the benefits of this type of mutual fund. Thus, a very small sum of money is required to invest in such financial instruments.
4. Exposure to ETFs
Through such funds, you can get exposure to ETFs even if you do not have a Demat account. You can also do SIP in the ETFs through FoF. These funds also eliminate concerns, such as brokerage cost, liquidity on exchange, spread on the exchange, etc.
5. Ease of Handling
There is just one folio and one NAV to track, which makes it easier to handle and manage your portfolio.
6. Credible Fund Managers
You can stay assured of the fact that highly experienced and skilled fund managers manage such funds.
Here are some of the drawbacks that you might face if you invest in Fund of Funds:
1. Inability to Choose Underlying Funds
If you invest in a FOF, you cannot choose the funds that the fund manager decides to invest in. Every fund of fund follows a specific asset allocation strategy; once the fund manager allocates the assets in a specific type of funds, your investments will get exposure to all of their underlying securities.
In case you do not find the allocations ideal, you have the option to redeem your units.
2. Higher Management Fees
The management charges of FoFs tend to be high as it includes the expense ratios of the underlying funds as well. Additionally, there are entry and exit loads that need to be borne by the investor during the purchase and redemption of mutual fund units.
3. Portfolio Duplication
As a fund of funds invests in several mutual funds, they might have exposure to the same stocks or debt securities across several funds. This will limit diversification and lead to portfolio duplication.
4. Over diversification
Diversification might be one of the advantages of FoFs; however, there’s also a risk of over-diversification. Investing in too many mutual funds that already have a well-diversified portfolio spread across companies of varied market capitalisations and sectors can lead to over-diversification. This increases the operation costs and somehow dilutes the advantages of diversification.
5. Low returns
Since the funds get more diversified, they offer comparatively average returns than regular mutual funds. Investors with adequate knowledge about the stock market can consider investing in individual mutual funds to earn better returns.
6. Low transparency
As there is lower visibility of the underlying investments of the selected funds, it might be more difficult for the fund managers and investors to keep track and monitor the holdings of the fund.
Who Should Invest in Fund of Funds?
An FoF is a suitable option for you in case you are looking to invest in more than one mutual fund scheme. Additionally, you may choose to invest in an FoF in case you don’t have a high-risk appetite.
Since these mutual fund schemes offer diversification by allocating funds to various schemes, the level of risk is low.
Note that you must make sure to identify your investment objectives and assess your own risk profile before allocating your savings to a fund of funds.
Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
What are the Limitations of Investing in FoFs?
Given below are the limitations of investing in an FoF:
1. Payment of tax
One needs to pay taxes on both short term and long term capital gains as applicable. With respect to FoF, the investor needs to pay taxes during the redemption of the principal amount. However, dividends of the investment are not taxable. In this case, the asset management company pays the amount.
2. Expense ratio
The expense ratio for FoF management is higher than for mutual funds. The fund house deducts the expense amount from the annual returns. There are added expenses as well. It includes selecting the assets for investment.
3. Difficulty in identifying a fund manager
Investors might face difficulty identifying the right fund manager to support their investment in an FoF.
4. Overlapping of assets
In many cases, it has been seen that assets in an FoF overlap with assets that an investor already holds.
Taxation of Fund of Funds Schemes
As per the current income tax regime in India, an FoF is considered a non-equity fund even if it invests in equity-oriented mutual fund schemes.
Returns earned from the sale of units before 3 years are classified as short term capital gains (STCG). Such gains are taxed as per your income tax slab rate.
But if the units are sold post 3 years from the date of purchase, the gains are known as long term capital gains (LTCG). A tax rate of 20% is applicable on LTCG after indexation.
Here are certain factors you should consider before investing in Fund of Funds:
Check the returns: There are risks associated with every investment. However, one needs to check the strategies of the fund house for providing risk-adjusted returns.
Performance against index: The investor can evaluate and compare fund performance against the relevant index.
Define your financial and investment goals: It is important for the investor to define his/her investment goals for proper evaluation of a fund’s performance.
Analyse previous performance: Investors can check previous performances of the FoF. The data accumulated would let the person know how it has performed across market cycles. Moreover, analysis of previous data would also provide crucial information about the skills of the fund manager.
Fund of funds allow investors to benefit from passive investments and get exposure to index funds and ETFs and diversification. In addition, well-informed fund houses monitor FOFs and generate higher returns through these schemes.
Mutual funds are always subject to market-related risks.
That said, a fund of funds provides low-risk returns as they invest in multiple mutual fund schemes. It’s advised to do proper research before investing in a fund.
FAQs On Fund of Funds
Q1. Does a fund of funds come with a lock-in period?
Ans: No, a fund of funds does not have a lock-in period. You can redeem your units after placing a redemption request.
Q2. What are the factors that I should take into account before investing in a fund of funds?
Ans: Before investing in an FoF, you must consider some essential factors, which include the following: Investment goals Risk appetite Past returns of the fund Expense ratio
Q3. Are investments in a fund of funds eligible for tax deduction under section 80C of the Income Tax Act, 1961?
Ans: No, there are no tax benefits in the case of FoF investments under Section 80C of the Income Tax Act.
Q4. When to invest in a Fund of Funds?
Ans: There is no specific time to invest in FoFs. You can invest when you have decided on your financial goals and investment time horizon. However, it is always prudent to assess your risk appetite before investing.
Q5. What is the maximum expense ratio for a fund of funds?
Ans: As per SEBI norms, FoFs that primarily invest in ETFs, index and liquid funds can charge an expense ratio of not more than 1%. The ceiling for FoFs predominantly investing in actively-managed funds is as follows: For equity-oriented funds: 2.25% For non-equity-oriented funds: 2%
Q6. What are the tax implications of fund of funds?
Ans: If a FOF invests 90% or more in India’s equity ETFs (90% or more in stocks of Indian companies), the taxation is similar to that of equity-based funds. If it invests in a mix of domestic equity fund schemes or international funds, the tax rate is the same as that of debt fund schemes.
Q7. How does a fund of funds work?
Ans: For understanding how FoF functions, an investor needs to know the concepts of unfettered and fettered management. Unfettered management refers to a situation in which a mutual fund invests in external mutual funds, i.e. in funds of other asset management companies (AMCs). In contrast, fettered management denotes a situation in which a mutual fund invests in the funds and assets of its own company.
Q8. Which FoFs are considered to be the safest?
Ans: Gold funds are considered to be one of the safest investments. Investing in gold funds is similar to buying physical gold items without the issues such as wealth tax, sales tax or GST. The investment is safe since the market price of gold never drops extensively and, therefore, draws favourable yields.
Q9. What are expense ratios?
Ans: An expense ratio signifies a fee that covers the operating costs of a mutual fund annually. The costs include the manager’s salary, auditing fees, accounting expenses, recordkeeping, registrar fees, legal services and custodial services. It is calculated as operating costs divided by the average value of mutual fund assets.
Q10. What are some limitations of FoF?
Ans: The expense ratio of FoFs is relatively higher than a standard fund. Investors have to bear the recurring costs of the particular FoF scheme along with the costs of the underlying schemes wherein the FoF scheme invests. An investor needs to gain information on the underlying costs of FoFs.
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Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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