What Are Fund of Funds (FoFs) and How Do They Work?

When exploring mutual funds, you may come across a category known as a fund of funds. The name itself might sound complex, but the concept is fairly straightforward. Essentially, these funds are designed to invest in other funds rather than directly in stocks, bonds, or other securities. This approach helps investors gain broader diversification and access to multiple strategies within a single investment.

In this article, we'll explain what are fund of funds, their structure, advantages, and how they operate so you can understand whether this type of investment suits your financial goals.

Understanding Fund of Funds

A fund of funds (FoF) is a pooled investment instrument that invests in a portfolio of other funds. These could include mutual funds, exchange-traded funds (ETFs), hedge funds, or other similar instruments. Instead of investing directly in companies or assets, the fund manager selects a combination of other professionally managed funds.

In simple terms, it's like having a basket of baskets. Each basket (underlying fund) holds a variety of assets, giving you access to several investment styles and markets through a single scheme.

For example, if a FoF invests in five different equity mutual funds, you automatically gain exposure to all the companies held by those funds, potentially hundreds of stocks across sectors and market capitalisations.

Types of Fund of Funds

There are several kinds of fund of funds, each with its own focus and purpose.

• Domestic FoFs: These invest in other funds that operate within the same country. For instance, a domestic FoF in India may invest in multiple Indian equity or debt mutual funds.
• International FoFs: These provide exposure to global markets by investing in overseas funds. It's one way for investors to diversify geographically without directly purchasing international securities.
• Asset Allocation FoFs: These funds invest across different asset classes, it may be equity, debt, and gold funds, based on market conditions or a fixed ratio. The aim is to balance risk and return through diversification.
• Target Date or Goal-Based FoFs: Designed for specific time horizons or financial goals, these funds gradually shift their allocation from riskier to more stable assets as the target date approaches.

How Fund of Funds Work

To understand how does a fund of funds works, think of it as a layered investment structure. The FoF collects money from investors and allocates it to various underlying funds. Each of these funds then invests in individual securities.

Here's a simplified step-by-step view of how FoFs function:

• Investor Contribution: Investors pool their money by buying units of an FoF.
• Manager Selection: The fund manager analyses and selects the underlying funds based on their track record, strategy, performance consistency, and risk levels.
• Diversification: The FoF spreads the investment across multiple funds, perhaps an equity fund, a debt fund, and a gold fund to reduce risk and capture opportunities from different segments.
• Monitoring and Rebalancing: The FoF manager regularly reviews the performance of each underlying fund and rebalances the portfolio if needed to align with the fund's investment objective.

This structure offers professional management at two levels, both at the FoF and the underlying fund level.

Benefits of Fund of Funds

There are several benefits of fund of funds that make them an appealing choice for investors seeking diversification and convenience.

• Wide Diversification: A FoF spreads investments across multiple funds, which means the impact of poor performance by one fund may be offset by better returns from another.
• Professional Fund Management: Investors benefit from the expertise of fund managers at both layers, those managing the FoF and those running the underlying funds.
• Simplified Access to Global or Niche Markets: Through international or theme based FoFs, investors can access specialised markets or sectors that may otherwise be difficult to invest in directly.
• Convenience for New Investors: Instead of researching and maintaining multiple mutual funds, a FoF offers a one-stop option for diversification and professional oversight.

Key Considerations Before Investing

While fund of funds offer several advantages, they also come with certain factors investors should keep in mind.

• Expense Ratio: Since FoFs invest in other funds, there are two layers of costs, the expense ratio of the FoF itself and those of the underlying funds. This could make the overall cost slightly higher compared to direct mutual fund investments.
• Taxation: In India, FoFs are generally taxed based on the asset class they invest in. For example, if a FoF primarily invests in equity funds, it's treated as an equity oriented scheme for tax purposes. Non-equity FoFs are taxed as debt funds. Always check the specific tax implications before investing.
• Overlap Risk: Even though FoFs are diversified, the underlying funds might hold some of the same securities, leading to portfolio overlap.
• Performance Dependence: The returns of a FoF depend on how well the underlying funds perform. Hence, it's important that the FoF manager chooses and monitors these funds carefully.

Is a Fund of Funds Right for You?

A fund of funds may suit investors who want a well-diversified portfolio without the effort of managing multiple individual funds. It's also suitable for those seeking exposure to global markets or asset classes beyond domestic equities.

However, if you are comfortable selecting and managing your own mix of mutual funds, or if you wish to keep costs lower, you might prefer investing directly in funds instead.

Understanding what is fund of funds in mutual fund terms helps you make better-informed decisions aligned with your financial goals and risk appetite.

Conclusion

A fund of funds simplifies diversification by allowing you to invest in multiple mutual funds through one scheme. It provides exposure to varied markets and strategies, managed by experienced professionals. However, investors should be aware of the additional costs and potential overlaps before committing funds. If you're exploring ways to create a balanced and diversified investment portfolio, understanding how FoFs operate is a great place to start. Learn more about different mutual fund categories and make informed investment decisions with Indiabulls Securities Limited (formerly known as Dhani Stocks Limited).

Disclaimer

Mutual fund investments are subject to market risks, read all scheme related documents carefully

FAQs

1. Are fund of funds suitable for beginners?

Yes, FoFs can be a good choice for new investors who prefer a diversified portfolio managed by professionals, without needing to select individual funds.

2. Do fund of funds guarantee returns?

No, FoFs do not guarantee returns. Their performance depends on the underlying funds and overall market conditions.

3. Can I redeem my investment in a fund of funds anytime?

Most FoFs offer liquidity similar to mutual funds, allowing redemptions on business days, except for funds with specific lock-in periods.

4. How are fund of funds different from multi-asset funds?

While FoFs invest in other mutual funds, multi-asset funds invest directly across asset classes like equity, debt, and gold.