Investors looking for diversification often come across the term Fund of Funds (FoF). But what is Fund of Funds, and how does it work? Unlike traditional mutual funds that invest in stocks, bonds, or commodities, a Fund of Funds invests in other mutual funds. This structure provides broad diversification and professional fund management while reducing the need for individual decision-making.
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This guide explains what is Fund of Funds, its types, benefits, risks, and how it compares to traditional mutual funds.
What is Fund of Funds?
A Fund of Funds (FoF) is an investment fund that pools money from investors and allocates it across multiple mutual funds instead of investing directly in assets like equities or bonds. This structure allows investors to gain exposure to various asset classes, geographies, or investment strategies through a single fund.
How Fund of Funds Work
- Investors buy units of a Fund of Funds
- The FoF manager selects and invests in multiple mutual funds
- Each underlying mutual fund manages its own portfolio of stocks, bonds, or commodities
- Returns are generated based on the combined performance of all selected mutual funds
By investing in a Fund of Funds, investors do not need to analyse and choose individual funds themselves. Instead, a professional fund manager handles asset allocation and diversification.
Types of Fund of Funds
1. Asset Allocation FoFs
These funds invest across equity, debt, gold, and other asset classes to optimise risk-adjusted returns. They are ideal for investors looking for automated rebalancing based on market conditions.
2. International FoFs
These funds invest in international mutual funds, providing exposure to global markets. They help investors diversify beyond domestic equities and access companies in developed or emerging markets.
3. Gold and Commodity FoFs
These funds invest in gold ETFs or commodity-based mutual funds, offering a hedge against inflation and currency risks. They are suitable for investors looking to add non-equity assets to their portfolio.
4. Hedge Fund FoFs
These funds invest in multiple hedge funds, aiming for high returns through alternative investment strategies. They are typically suitable for high-net-worth individuals seeking sophisticated portfolio management.
5. Passive Index FoFs
These funds invest in exchange-traded funds (ETFs) or index funds, tracking benchmarks such as the Nifty 50 or S&P 500. They provide low-cost exposure to broad market indices.
Advantages of Investing in Fund of Funds
1. Diversification Without Complexity
By investing in multiple funds, a Fund of Funds spreads risk across various asset classes and investment strategies. This reduces the impact of poor performance from any single fund.
2. Professional Fund Management
Fund managers actively monitor and rebalance the portfolio by selecting the best-performing mutual funds. This benefits investors who prefer professional expertise over direct fund selection.
3. Access to High-Value Funds
Some high-performing mutual funds require large capital investments. A Fund of Funds allows small investors to gain exposure to such funds without needing a large upfront investment.
4. Risk Mitigation
Since Fund of Funds invest in multiple funds, they are less volatile than standalone mutual funds. The diversification across different asset classes helps reduce overall risk.
Disadvantages of Investing in Fund of Funds
1. Higher Expense Ratios
Since a Fund of Funds invests in multiple mutual funds, investors pay two layers of fees – one for the FoF and another for the underlying mutual funds. This increases the overall cost.
2. Limited Control Over Investments
Unlike direct mutual fund investments, where investors choose their funds, a Fund of Funds is managed entirely by professionals. Investors have no direct say in the selection of underlying funds.
3. Tax Inefficiency
In India, Fund of Funds are taxed as debt funds, regardless of whether they invest in equity funds. This makes them less tax-efficient than direct equity mutual funds, which enjoy favorable long-term capital gains tax rates.
Fund of Funds vs. Mutual Funds
| Feature | Fund of Funds (FoF) | Mutual Funds |
|---|---|---|
| Investment Type | Invests in multiple mutual funds | Invests directly in stocks, bonds, or commodities |
| Diversification | High (spread across funds) | Depends on the investment strategy |
| Expense Ratio | Higher due to multiple layers of fees | Lower compared to FoFs |
| Control | Fund manager decides the allocation | Investors can select specific funds |
| Taxation | Taxed as debt funds, even if investing in equity | Taxed based on fund category (equity or debt) |
Who Should Invest in a Fund of Funds?
Suitable for:
- Investors who want diversification without actively managing multiple funds
- Beginners looking for a hands-off approach to investing
- Those who want exposure to global markets, gold, or alternative assets
- Investors with limited knowledge of fund selection and asset allocation
Not Suitable for:
- Investors who prefer low-cost, direct mutual fund investments
- Those who want full control over fund selection and strategy
- Investors who focus on tax efficiency and long-term equity benefits
How to Invest in a Fund of Funds?
- Choose the Right Category – Decide whether you need an asset allocation FoF, international FoF, or a commodity-based FoF based on your investment goals.
- Check Expense Ratios – Compare the cost structure with direct mutual fund investments to ensure that fees do not erode returns.
- Analyse Performance and Fund Manager Expertise – Look at historical returns, asset allocation strategy, and fund manager experience.
- Invest via Mutual Fund Platforms – Fund of Funds are available on online investment platforms, brokerage apps, and banks.
Conclusion
Understanding what is Fund of Funds helps investors make informed decisions about portfolio diversification. A Fund of Funds simplifies investing by offering exposure to multiple mutual funds, reducing the need for active management.
However, the higher costs, tax inefficiencies, and lack of direct control may make them less attractive for certain investors. Before investing in a Fund of Funds, evaluate personal financial goals, risk appetite, and cost-effectiveness compared to direct mutual fund investments.
For those looking for broad diversification, professional fund management, and an easy investment experience, Fund of Funds can be a valuable addition to their portfolio.
