Fund of funds (FoF): What are they and how do they work?

A Fund of Funds (FoF) is a type of mutual fund that invests in other mutual funds or ETFs rather than investing directly in stocks, bonds or other securities.

Thus, FoFs hold a basket of underlying funds and can provide investors with wide diversification and access to multiple fund managers and strategies. It also allows fund managers to construct diversified portfolios based on their investment outlook without having to manage the underlying assets directly.

• Table of contents

1. How does FoF work?
2. Types of Fund of Funds (FOFs)
3. Advantages of Fund of Funds
4. Limitations of Fund of Funds
5. Who should invest in Fund of Funds?
6. How to invest in Fund of Funds

How does FoF work?

A Fund of Funds operates by pooling money from multiple investors and investing that money into a group of pre-selected mutual funds. These could be mutual funds owned by the same asset management company, or other asset management companies.

The manager of a Fund of Funds selects the group of funds to include based on investment objectives, past performance, risk tolerance and other parameters. An FoF could invest in a variety of fund types across various asset classes, market sectors, investment styles and fund managers. The underlying funds may include equity funds, fixed income funds, alternative investment funds and mixed allocation funds.

Types of Fund of Funds (FOFs)

Here are some of the types of FoFs in India:

1. Multi-asset/Asset allocator Fund of Funds: Invests in different asset classes such as equity, debt, gold, and sometimes other alternatives like real estate investment trusts. Aims to leverage different market opportunities and achieve an optimal risk-reward balance.
2. International Fund of Funds: These invest in overseas mutual funds or ETFs, allowing Indian investors to access international markets.
3. Commodities Fund of Funds: These invest in silver or gold ETFs. Thus, they allow investors exposure to these asset class without requiring them to physically own them.
4. Sectoral/thematic Fund of Funds: These invest in international and/or domestic funds specializing in specific sectors or themes such as mining, artificial intelligence, or ESG (environmental, social, and governance) themes, among others.

Advantages of Fund of Funds

Investing in Fund of Funds can offer investors the following benefits:

Diversification

The primary benefit of FoF investing is instant diversification. By buying units in just one FoF, investors gain exposure to a basket of mutual funds across various asset classes, market sectors, investment styles and fund managers. This diversification helps mitigate portfolio volatility and risk. It also makes it more affordable than investing in multiple mutual fund schemes individually.

Ease of investing

Instead of having to consult a financial advisor to identify a suitable portfolio mix, a fund of fund allows investors to achieve a potentially balanced portfolio through a single investment.

Professional fund management

In an FoF, the selection, due diligence and ongoing monitoring of the underlying funds is handled by a professional fund manager. Investors can leverage the expertise of the FoF manager in identifying the top-performing funds to include within the portfolio. Additionally, they also get access to the skills of other fund managers whose schemes are in the portfolio.

Limitations of Fund of Funds

• Higher expense ratios: A management fee is charged at both the FoF level and the underlying fund level, leading to overall higher costs for investors.
• Over diversification: If the fund is diversified across too many funds, markets or strategies, it may dilute the return potential and efficacy.
• Performance dependency on underlying funds: The performance of a FoF depends entirely on the performance of its underlying funds. If the selected funds underperform, the FoF will also underperform, regardless of its management strategy.
• Less control for investors: Investors cannot directly choose the underlying funds or asset allocation. They must rely on the fund manager's expertise, which may not align with their personal risk tolerance or investment goals.

Who should invest in Fund of Funds?

• Retail investors: FoFs allow small investors to gain professionally managed diversification across asset classes and fund managers with a single investment.
• Passive investors: For investors not keen on actively monitoring and rebalancing a portfolio of funds, FoFs can provide a low-maintenance hands-off investment solution.
• Investors seeking risk mitigation: Investors who want to reduce the risk of investing in a single mutual fund/category may find FoFs suitable.

How to invest in Fund of Funds

• Identify investment goals - First determine your targeted asset allocation, risk tolerance and return objectives. This will help narrow down suitable FoF strategies.
• Research FoF managers - Analyse and compare the investment process, performance track record, expenses and portfolio composition of shortlisted FoFs.
• Evaluate diversification - Check that the FoF holds a sufficiently diversified basket of underlying funds in terms of the number of funds as well as the variety of asset classes, sectors, geographies and strategies covered.
• Understand the fee structure - Consider the FoF’s expense ratio to gauge the total cost of investing.

Conclusion

Fund of funds can provide a convenient way for investors to achieve diversification across investment strategies, fund managers, mutual fund houses and asset classes through a single investment plan. Their instant diversification and professional management can make them a suitable vehicle for retail investors looking to access a widely diversified investment avenue without having to manage multiple individual mutual fund investments. However, investors need to be aware of the limitations of FoFs in terms of higher costs and the risk of over-diversification.

FAQs:

How do funds of funds mutual funds differ from traditional mutual funds?

Funds of funds mutual funds invest in a basket of other mutual funds rather than directly in stocks and bonds like traditional mutual funds. This provides built-in diversification across funds and managers.

What types of assets do funds of funds typically invest in?

Funds of funds can invest in a variety of mutual funds across asset classes like equities, fixed income, commodities, and alternatives as well as across investment styles, sectors, market caps, and geographies.

What are the key considerations when evaluating funds of funds?

Look at the expense ratio, portfolio composition, manager tenure, performance history, and risk-adjusted return metrics, relative to benchmarks, when evaluating a Fund of Funds.

Is Fund of Funds a good investment?

Fund of Funds can be a suitable investment for diversification and access to professional management, but higher costs and over-diversification may limit return potential for some investors.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.