A Beginner's Guide to Investing in Fund of Funds

Introduction

Today, one of the most attractive instruments for investors is mutual funds. The key reasons for the popularity of mutual funds are that they come with less risk and higher returns, liquidity, as well flexibility when it comes to investment and redemption. Within the spectrum of mutual funds, an emerging category is gaining popularity among investors. Known as a fund of funds (FOF), this is a pooled investment opportunity where funds are invested across a wide range of mutual funds, which have exposure to equity, gold, ETFs, hedge funds, and other asset classes.

Also known as a multi-manager investment, the portfolio of a fund of funds comprises portfolios of other mutual funds. However, investors' funds are not directly invested in any instruments such as stocks, bonds, and other market instruments. The fund of funds aims to offer investors more diversity without the risk of direct investments into multiple asset classes. If you're still grappling with the question - what is a fund of funds - read on to brush up on your knowledge and make well-informed investment decisions.

Quick Facts

Here's a quick run-down of fund of funds mutual funds. 

• A fund of funds (FOF) is a category of mutual funds where investments are made in other mutual funds that have exposure to a mix of asset classes, markets, and businesses with varying market capitalization.
• The core aim of a fund of funds is to increase diversification, minimize risk, and maximize returns.
• Typically, investors pay a higher fee for funds of funds in the form of an expense ratio because dedicated fund managers actively manage the fund.
• Based on the FOF strategy, it may diversify across debt, equity, balanced advantage, index, and other types of funds. It aims to actively optimize market opportunities. 
• A fund of funds may invest across both domestic and global mutual funds. In the latter, the fund will invest in international mutual fund schemes. 
• Wealth creation is a core goal for portfolio managers of fund of funds. 
   

Ideal Investor Profile

Investing in any market-linked instrument always comes with certain risks. Since a fund of funds is designed to mitigate risk while offering maximized returns, this opportunity is relevant for those who do not wish to invest directly in the stock market due to the risk factor. The element of diversification offered by the fund of funds also makes it attractive to investors who want to invest in smaller amounts and have a time horizon of five or more years. 

Types of Fund of Funds

Multi-Manager Fund of Funds
This is a fund of funds that invests in mutual funds with exposure to a wide range of sectors and businesses of varying market caps. The diversification within each fund of funds is so broad that each FOF has multiple managers responsible for different funds within a single portfolio, bringing their specific expertise to that part of the investment.  

Asset Allocation Fund of Funds
This category of fund of funds invests in mutual funds that are invested across a diverse mix of asset classes - from equity-oriented, debt-oriented, gold, and other types of commodities. This type of diversification helps bring in a mix of risk and returns, as well as the ability to capitalize on market opportunities across the asset classes. 

Gold Fund of Funds
There is a growing number of mutual funds invested in physical, digital gold, gold ETFs, and gold securities. A gold fund of funds specifically invests in a mix of gold funds. Investors can be indirectly invested in a wide range of gold mutual funds through this category of fund of funds. 

ETF Fund of Funds 
As the name suggests, exchange-traded funds are a type of mutual fund that can be bought and sold like stocks, in real-time, unlike regular mutual funds. An ETF fund of funds invests across a range of ETFs. One key advantage is that investors do not need to have a Demat account to invest in an ETF fund of funds. 

International Fund of Funds
Today, investors can benefit from global market opportunities by expanding their portfolio to include international fund of funds. As the name suggests, international FOFs are offshore mutual funds that invest overseas across equity, bonds, and other types of instruments
 

Seven Must-Knows about Funds of Funds

Here's a quick run-down of what investors must know about this unique instrument:

Ease of use 
As an investor, a fund of funds is easy to purchase and redeem, as they come with one folio number and NAV. Like any mutual fund, the price is set and fixed during the trading day. An investor does not need to own a Demat account to buy and sell FOFs. 

Tax benefit 
When rebalancing happens within a fund of funds, its advantage is that it has no tax implication on the capital gains. It is considered an internal transaction. 

Professionally managed fund
It is challenging for new investors to choose multiple mutual funds since they lack savviness about the market. Fund of funds comes with the benefit of being invested in numerous funds actively managed by professionals with a proven track record. 

Diversify with limited funds
Fund of funds enables investors with limited capital to access diversified portfolios. Typically, you would need to invest individually in multiple asset classes to build a diverse portfolio.  

Higher expense ratio
Since a fund of funds is actively managed by professional portfolio managers, a higher fee is charged for this service. Known as an expense ratio, it is typically higher for funds of funds because it is charged on each mutual fund within the fund. 

Tax implications
Fund of funds is taxed like debt funds. Short-term capital gains tax is applicable if you sell units of your fund of funds before 36 months. If sold after 36 months, the long-term capital gains tax is subjected to 20% with indexation.

Duplication of assets
Sometimes, a FOF may invest in mutual funds with similar assets in their portfolios. This may lead to an illusion of diversification instead of actual diversification. 
 

How to Choose a Fund of Funds?

With so many FOFs flooding the market, it's important to choose wisely, based on what will fit into your portfolio and add the most value. When zeroing in on a fund of choice, keep the following in mind:

• Look up the performance of the fund of funds over the last five years, and especially see how it has performed during volatile markets and black swan events like the pandemic. 
• Every fund of funds is invested in a range of mutual funds - familiarise yourself with the sectors, markets, and assets, in which these funds are invested. You want to make sure there is limited duplication to be as diversified as possible. 
• Choose a fund of funds that helps further diversify your portfolio. For instance, if you mostly have fixed interest investments, you can explore a fund of funds diversified into equity-oriented mutual funds. 
• Every fund of funds may be handled by one or more portfolio managers. Look up their track record to understand their strategy and approach.
• Understand how your FOF is taxed, and plan purchases and redemptions accordingly. 
• When comparing various FOFs, note the expense ratio to know the fees being charged. 
   

The Takeaway

Fund of funds is a good option for those investors with access to less capital, seeking more value through diversification, returns, and risk management. Ideally, you should have a separate emergency fund with 12 months' living expenses so that you do not need to reach into your fund of funds investment for contingencies. Additionally, you should stay invested with a time horizon of five years and beyond to maximize market opportunities. The longer you remain invested, the higher the returns.