Hidden cost of Fund of Funds that you should know before investing

Fund of Funds (FoFs) have gained popularity since last year due to the tax advantage brought in this category in the Union Budget presented in July 2024.

According to data by the Association of Mutual Funds in India (AMFI), the net assets under management (AUM) of domestic FoFs increased by over ₹26,000 crore between July 31, 2024, to May 30, 2025.

As of July 31, 2024, the net AUM of domestic FoFs was ₹81,742 crore, which increased to ₹1,08,136 crore by May 30, 2025.

Compared to debt funds that are taxed at slab rates, many FoFs have become more attractive. This is because long-term capital gains (LTCG) from a FoF are taxed at 12.5% after two years, provided the fund is not classified as a specified mutual fund (i.e. a fund having 65% or more investment in debt).

According to a note by DSP Mutual Fund, the following categories of fund of funds have seen an increasing investor interest since last year:

• Income Plus Arbitrage FoF: This type of FoF invests in a mix of arbitrage and debt funds, with exposure to debt funds below 65%. With this asset allocation structure, the Income Plus Arbitrage FoF becomes a tax-efficient investing option, as long-term capital gains from it after two years are taxed at 12.5% plus surcharge and cess, which is lower than the slab rates applied to traditional debt funds.
• Gold ETF FoF and Silver ETF FoF: This type of FoF allows investing in the precious metals by holding ETFs that track gold and silver prices without the necessity of holding a demat account.

Although FoFs are gaining popularity, they have a hidden cost that many investors do not know.

Generally, when you invest in a mutual fund, the Total Expense Ratio (TER) is deducted from the fund's assets. However, in the case of Fund of Funds (FoFs), you have to effectively pay for two types of expenses:

• the expense of the FoF and

• the underlying fund's expenses.

Therefore, before investing in a FoF, you should compare the total cost of ownership, which is especially crucial for Gold and Silver ETF FoFs as their returns are tied to the commodity prices or for Income Plus Arbitrage FoFs where every basis point matters.

"With FoFs, total cost of ownership is crucial, especially for categories like Gold and Silver ETF FoFs (where returns are closely tied to commodity prices and not fund manager skill), or Income Plus Arbitrage FoFs (which aim for debt-like returns, where every basis point matters). Investors often focus only on the expense ratio of the FoF wrapper (the fund that they directly invest in), without realising that there’s also an additional hidden cost: the expense ratio of the underlying fund(s). What truly matters is the Total Expense Ratio (TER)," the note says.

What should investors do?