What are Fund of Funds - Types, Advantages and Disadvantages

Your favourite restaurant is not usually just one place. Often it is the food that you like from a certain place. For example, you might like the pav bhaji from one restaurant and the pasta from another restaurant. But to have both at one time, you have to visit two different places. Now, imagine if you could visit just one restaurant and have the pav bhaji from your favourite restaurant as well as the pasta from your other favourite restaurant. Something like a food court. There is a similar concept in the world of investing as well. However, instead of being called a food court, it is called a Fund of Fund (FoF).

Let us understand what is Fund of Funds. Given the popularity of mutual funds, you must be already aware of how mutual funds work. To give a quick recap, mutual funds are investment vehicles that pool investor money and then invest it in a wide variety of asset classes like equity, debt, and gold and as per different investment strategies. The choice of asset class or investment strategy is as per the investment mandate of the particular scheme. Now, when a mutual fund scheme  invests in other mutual fund schemes it is called a Fund of Fund, i.e., instead of directly investing in equity or debt securities, it invests in other funds. An FoF can invest in funds from the same fund house or it can also choose to invest in funds from another fund house.

Different types of FoFs that you should know about

While there are different types of FoFs available in the market, here are the top few that you should be aware of:

• Asset Allocation Funds: These FoFs invest in other funds with the goal of investing across multiple asset classes. For example, they could invest in one equity mutual fund scheme, one debt fund scheme, and one gold fund scheme. The idea is to gain exposure to a range of asset classes which could include equity, debt, gold and other commodities.
• International Funds of Funds: These FOFs invest in international mutual fund schemes, i.e., mutual funds that directly invest in global companies or invest in global funds that can provide exposure to global companies.
• Gold Funds: These FOFs aim to give exposure to gold price movements by investing in physical gold, stocks of companies that are into gold mining, or even gold Exchange Traded Funds (ETFs).
• Multi-Manager Funds of Funds: These are FoFs that invest in other mutual fund schemes based on the managers that are managing the different schemes.

Things that you need to know about FoFs

Now that you know about the different types of FoFs available in the India Indian markets, let us understand whether you should invest in FoFs. For this, let us first go through the advantages and disadvantages of FoFs.

Advantages of FoFs: How FoFs can add value to your portfolio

• Easy to invest: Just like in our restaurant example, where a food court makes it easy for you to consume all your favourite dishes under one roof, an FoF can give you exposure to multiple mutual fund schemes through a single investment. Further, tracking, reviewing, and managing your investments also becomes easier compared to multiple individual funds.
• Ease of rebalancing: Rebalancing is an important part of optimally managing your investment portfolio. However, every time you rebalance your portfolio you might need to sell some investments and buy another set of investments. Selling investments means that you might also need to pay capital gains tax, wherever applicable. However, when FoFs rebalance their portfolios, this transaction does not attract any capital gains tax. This means that rebalancing fund assets internally is tax-free. Thus, you can get the benefits of rebalancing without having to pay the tax liability.
• Provide small investors easy access to investments: Small investors who have limited funds find it difficult to achieve diversification by investing in multiple mutual funds schemes. However, FoFs can prove to be an ideal choice for investors with low capital as these investors can gain access to multiple funds through a single investment.

Disadvantages of FoFs: Things that you need to be aware of before investing in FoFs

• High Expense Ratio: All mutual fund schemes incur some expenses attributed to the management of the fund. Since the fund manager of an FoF is managing investments in multiple funds, these funds tend to have higher expenses compared to other mutual fund schemes. Interestingly, investors of FoF have to additionally bear the expenses of the underlying schemes in which the FoF has invested.
• Portfolio duplication: Since FoFs invest in multiple fund schemes, there is always a possibility that some of the underlying funds or securities might already be in your investment portfolio. This leads to an overlap and reduces the diversification benefit of investing in multiple schemes.

Tax Implications of FoF

In the case of debt FoFs and international FoFs, the short-term capital gains (STCG) tax is applied as per the income tax slab of the individual investor in case the investment is redeemed within three years of purchase. Further, for investments sold after three years, long-term capital gains (LTCG) tax of 20% with indexation is applicable. In the case of equity FoFs, the STCG is 15% for gains made on investments sold within one year of purchase and the LTCG is 10% for gains that exceed Rs. 1,00,000 and are sold after one year of purchase.

The taxations aspect of FoFs that you must know

Should you invest in FoFs?

If you are somebody who does not have a lot of money to invest but still wants to achieve diversification by investing in multiple schemes, then an FoF can be a good investment option for you since through a single investment you can get the desired diversification. On the other hand, if you are an experienced investor who wants to add more investments to her portfolio but does not want the hassle of managing many investments, then an FoF would be ideal for you since you can increase your portfolio exposure through a since fund. However, before you invest in an FoF, make sure that there is not a high degree of overlap in terms of the other securities or investments in your portfolio and take note of the expense ratio of the FoF. Just like any other investment, ensure that it is well-aligned with your risk profile and fits well with your overall asset allocation strategy. Don’t look at investments in silos. Always consider them from the perspective of your overall investment portfolio.

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