A fund of funds is an investment strategy of holding a portfolio of other investment funds rather than directly investing in bonds, stocks, or other securities. As a result, you are getting access to broad exposure to multiple asset classes with less risk. In this blog, you will learn the concept of fund of funds, its working, benefits and limitations to make an informed decision.
Fund of Funds: What is It?
Fund of Funds is also referred to as a multi-manager investment strategy. It is a type of investment instrument that offers you the benefit and convenience of investing in different mutual funds through a single investment. It is a mutual fund that uses its pool to invest in other types of mutual funds. This is specifically designed to meet financial objectives and risk profiles of various investors.
This type of mutual fund is a feasible option for individuals who have access to a small pool of money that they can keep for an extended period. Ideally, if you are an investor with limited resources and low liquidity requirements you can choose to invest in the top fund of funds available in the market. This enables you to achieve maximum returns with minimal risk.
What Are the Types of Fund of Funds?
Here is the most popular fund of funds available in the Indian market:
Gold Funds
Investing in this mutual fund primarily signifies trading in gold securities. The gold FoF is a good option to invest in and they invest in gold ETFs.
Multi-manager Fund of Funds
The asset base of this fund consists of various professionally managed funds with varying portfolio concentrations. A multi-manager fund of funds has different portfolio managers, where each one is dealing with a particular asset present in the mutual fund.
Asset Allocation Funds
This fund invests in different assets like equities, gold, and debt, giving the opportunity to diversify the portfolio across a variety of asset classes.
International Fund of Funds
This type of fund invests in international funds like global companies. As a result, you get indirect exposure to large multinational companies without any hassle of opening a trading account with an overseas broker.
How Does a Fund of Funds Work?
Now that you know fund of funds meaning, let's understand how it works.
Mutual funds invest in different companies' stocks and debt instruments on behalf of their investors. Similarly, in FoF, a fund manager can invest in a single fund or funds depending on the underlying investment strategy.
What Are the Benefits of Fund of Funds?
If you want to invest in a single investment to achieve multiple investment goals, a fund of funds can be suitable. It offers some notable advantages:
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Diversification
One of the biggest benefits of fund of funds is that it offers access to different mutual funds with varying investment objectives through a single investment.
For instance, let’s say ABC Asset Allocator fund invests in 18 different equity and debt schemes of the ABC Prudential mutual fund. This endeavour would prove burdensome if you invest in each of these 18 schemes on your own.
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Convenience in Investing in International Markets and Gold
Investing in international FoFs enables you to invest in global companies without any hassle. To invest in stocks of multinational companies, you do not need to open a separate account with a different intermediary and can begin investing quickly. Also, gold funds provide an accessible way to invest in paperless gold.
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Easy Rebalancing
Rebalancing is critical for managing your investment portfolio. When you rebalance your portfolio, you might have to buy and sell some investments. If you sell investments, you need to pay capital gains tax. However, capital gains tax is not meant for portfolio rebalancing transactions which are carried out by various funds, constituting the FoFs.
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Opportunities for Investors with Limited Capital
If you are an individual with limited financial resources, you can easily invest in the top fund of funds to earn higher profits. In addition, when selecting a fund of funds to invest in, monthly investment schemes are also available.
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The Investment Style of Different Fund Managers
As FoFs can invest in both domestic and international funds, you get the opportunity of investing in a portfolio that is managed by different professional fund managers. They along with their research team conduct proper analysis to calculate market predictions. As a result, it ensures high returns through intricate investment strategies.
What Are the Limitations of Fund of Funds?
Let’s look into some of the limitations associated with fund of funds:
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Tax Implications
A favourable equity taxation is usually not available in fund of funds. In case the FoF invests 90% of the fund in any ETF, which invests in 90% of the asset in shares that are traded on the Indian stock exchange, it will be treated as equity fund.
In case an FoF is treated as an equity fund, for short-term gains the tax rate is 15% and for long-term gains it is 10% for any profit beyond ₹1 lakh. In case the FoF is treated as a debt fund, it will follow the tax rules of debt funds.
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Expense Ratio
Expense ratio to manage a fund of funds is typically higher than regular mutual funds. Apart from the administrative fees and general management fees, there is an added expense about this fund as they are responsible for the costs of the underlying schemes in which the FoF has invested. Additionally, SEBI has divided the FoFs depending on their underlying schemes and it has also set a cap on the expense ratio.
For instance, FoFs that primarily invest in liquid, ETF, and index schemes may charge up to 1%. While FoFs that invest in non-equity schemes and actively managed equity funds can charge up to 2% and 2.25% respectively.
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Flexibility
The fact that investors are unable to select the investment strategy or mutual funds in which a fund manager invests is a major limitation of FoF. If you don’t like a particular fund, you have no option but to keep investing or redeem your existing investment.
To have an in-depth understanding of this limitation let’s consider an example. Suppose the XYZ Passive Fund of Funds adheres to a strategy of strategic asset allocation and limits gold exposure to 10% for Conservative FoF and Aggressive FoF. So, if you want more exposure to gold, you cannot get it through this fund. You will need to make separate investments.
Wrapping It Up
When utilised effectively, fund of funds can be crucial for achieving your financial goals via asset allocation and diversification. Like mutual funds, FoFs are subject to market risk, so you need to proceed cautiously after learning the appropriate investing techniques or strategies.