Fund of Funds - Meaning, Types and Advantages

What is a Fund of Fund (FoF)? What does it mean?

A fund of funds (FoF) scheme is a mutual fund scheme that invests primarily in other schemes offered by the same mutual fund house or another mutual fund house. 
It is an investment strategy of holding a portfolio of other mutual funds rather than investing directly in Mutual Fund schemes. These schemes offer the investor an opportunity to diversify risk by spreading investments across other funds. Many FoFs work like feeder funds.
They usually invest in just one underlying fund. These funds can be used to invest in both domestic or international schemes as per the investment objective and defined asset allocation pattern of the scheme. This may help in achieving more diversification. 

Types of Funds of Funds

1. International Fund of Funds (FoFs): These funds provide investors with the exposure to international stocks, bonds or other instruments. They aim to offer global exposure with diversification and provide opportunities beyond the domestic market.
2. Gold Fund of Funds (FoFs): These funds invest in Gold ETFs which track the performance of Gold. These ETFs track the performance of physical Gold without physically owning the metal.
3. Passive Fund of Funds: These funds invest in Index Funds or ETFs (Exchange Traded Funds) that closely track the performance of an index. One advantage of taking exposure to ETFs in this manner is that there is no need to have a demat or trading account. However, the underlying risks associated with the ETF will still be applicable even for FoFs.
4. Sector-specific Fund of Funds: These funds concentrate on a specific sector or industry such as defense, energy, or electric vehicles etc. They invest in funds with a specific focus on a particular sector.
   
   Before choosing any of the funds, it is important to consider the investment objectives, investment strategy, financial goals and risk-return profile.

Advantages of investing in Fund of Funds (FoFs)

1. Diversification:FOFs offer exceptional diversification by investing in various underlying funds, spreading risk across multiple asset classes and investment strategies. This broader investment exposure may help mitigate the impact of individual poor fund performers on the overall fund performance.
2. Professional Management:Another significant benefit of FOFs is their professional management. Experienced fund managers conduct thorough due diligence, select quality funds, and continuously monitor and rebalance the portfolio. If done well, this expertise may lead to better asset allocation and risk management.
3. Simplified Investment Process:FOFs simplify the investment process by bundling multiple funds into a single mutual fund scheme. This convenience allows investors to achieve broad market exposure and possibly effective diversification and manage each investment themselves. 

Disadvantages of Investing in Fund of Funds (FoFs)

A few disadvantages of investing in FoFs are:

1. Higher Expense Ratios:FOFs may have higher expense ratios because of the expense ratios of underlying schemes. Investors pay fees not only for FOFs but also for underlying funds. These cumulative costs can impact the overall returns, which might make FOFs more expensive than direct fund investments.
2. Investment Complexity:Understanding and evaluating FOFs can be complex because of their multilayered nature. Investors may need to understand not just the strategy of the FOF but also the underlying funds' strategies and performance. This may make it quite difficult to evaluate the risks involved.

Should you invest in Fund of Funds (FoFs)?

While it is hard to mention if you should consider FoFs or not, there are a few points to consider before investing in the schemes.

1. Due Diligence: It is very important to evaluate the track record of the FOFs’ Fund managers, scrutinize the underlying funds' performance and strategies. A rigorous evaluation can help you understand the potential risks and rewards and give you more confidence when deciding. 
2. Self-Assessment: Assessing your investment goals and risk tolerance is crucial. Ensure you determine whether your primary goals are growth, income, or stability and that the chosen FoF aligns with your risk appetite.
3. Understanding expense ratios: FoFs tend to have significantly higher expense ratios compared to the underlying funds. These cumulative costs can greatly impact your overall returns. Therefore, it's essential to fully evaluate the fee structure before making a FOF investment. 

Conclusion

Investing in a Fund of Funds (FoF) presents a unique opportunity for investors seeking diversification and professional management without the complexity of managing multiple individual funds. FoFs allow investors to access a broad range of underlying funds, which can mitigate risk and potentially enhance returns through strategic asset allocation across various asset classes, including equities, bonds, and international markets.
However, potential investors should be mindful of the higher expense ratios that may be associated with FoFs, as they incur costs at both the fund-of-funds and underlying fund levels. This layered fee structure can significantly impact overall returns. Additionally, the complexity of evaluating FoFs, given their multilayered nature, requires thorough due diligence to ensure alignment with individual investment goals and risk tolerance.
They may not be suitable for all investors, especially those who prefer direct control over their investments or seek to minimize costs. Careful consideration of personal financial objectives and a comprehensive understanding of the associated risks and costs are essential for making informed investment decisions in the realm of Fund of Funds.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully

Please note that this article or document has been prepared on the basis of internal data/ publicly available information and other sources believed to be reliable. The information contained in this article or document is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party in any manner. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article or document.

Published on Aug 22, 2024