What are Funds Of Funds & How They Work

Investing in mutual funds can provide investors with diversified portfolios, but there’s an even broader level of diversification through Funds of Funds (FoF fund). A Fund of Funds is an investment strategy that involves pooling capital to invest in a selection of other mutual funds, ETFs, or other funds rather than investing directly in individual stocks, bonds, or other assets.  This article will explore what Funds of Funds are and how they work.

What Is a Fund of Funds?

Fund of Fund Meaning: A Fund of Funds is a pooled investment fund that invests in other funds, not directly in stocks, bonds, or other securities. It is a fund that holds shares in some number of other mutual funds or ETFs. 

FoF funds are designed to be one-stop solutions for investors who want exposure to a range of sectors, asset classes, and investment strategies. Instead of individually researching and managing investments in different funds, an investor can place their money in a Fund of Funds, which provides a professionally managed, diversified portfolio of funds.

A Fund of Funds is normally managed by an investment manager who distributes the investments into a portfolio of other funds based on a variety of criteria, including the risk tolerance of the investor, market conditions, and specific investment goals.

Funds of Funds Pool money raised by investors into the fund and invest that capital in a diversified portfolio of other funds. In the process, the fund manager of a FoF analyses a vast number of mutual funds, ETFs, and other investment funds to decide the most fitting combination appropriate to the goals of the fund. The role of the fund manager is then to diversify investments underway within the policy of risk tolerance and financial goals envisioned by the investors.

Types of Funds of Funds

Different kinds of FOF Funds, depending on their underlying funds as well as strategies, form different categories. 

Equity Fund of Funds: These funds are mainly invested in equity mutual funds or equity ETFs, expecting to generate very high returns based on the stock markets. The risk is higher, but the possibility of growth is also significant. 

Debt Fund of Funds: They invest in a mix of debt or bond mutual funds and ETFs. These are designed for investors seeking steady income with relatively lower risk. 

Balanced Fund of Funds (Hybrid): A balanced FoF invests in a mix of equity, debt, and other asset classes. The objective is to achieve a balance between risk and return. 

Global Fund of Funds: These funds invest in mutual funds or ETFs that provide exposure to international markets. Global FoFs are designed for investors who want to diversify their portfolios across global markets without directly investing in foreign securities or managing currency risk.

Alternative Investment Fund of Funds (AIFoF): This type of FoF invests in alternative investments such as private equity, hedge funds, commodities, or real estate funds. 

Target-Date Fund of Funds: A target-date FoF is designed for retirement planning. They automatically adjust the portfolio over time based on the retirement timeline.

Advantages of Investing in Fund of Funds

• Investing in a variety of funds automatically provides a diversified portfolio across sectors, asset classes, and geographical locations.

• FoFs are managed by professionals who have the expertise to allocate funds optimally across multiple underlying funds.

• FoFs enable the investor to have access to money that could otherwise be impossible or difficult to invest in, like international funds or niche funds. Investors benefit from expert know-how in those niches without having to personally select the funds.

• Fund of Funds is a convenient offering. It comes pre-packaged as a ready, diversified investment strategy. An investor does not need to personally research and manage many funds. Instead, it’s taken care of by the FoF.

Since they purchase a combination of funds, FoFs reduce some of the risks linked with investments in a single asset class. When one underlying fund loses value, others within the portfolio can offset this loss.

Disadvantages of Investing in a Fund of Funds

Although FoF Funds have their merits, there are some disadvantages and limitations that investors should also consider:

• FoFs are also known to charge higher management fees because they charge a fee over and above the fee paid by the underlying funds to manage their fund of funds. Additionally, these fees can be a huge drain on the overall return, especially if the underlying funds are actively managed as well.

• In some cases, the underlying funds of a FoF may have overlapping holdings, resulting in unintended concentration in some stocks or sectors. This may result in lowering the diversification offered by the FoF.

• The tax on Fund of Funds is mainly similar to that applicable for other mutual funds but depends on the nature of the underlying funds included in the FoF.

• If the Fund of Funds invests in equity-oriented mutual funds, the gains from these investments will be subject to Long-Term Capital Gains tax at 10% for holding periods longer than one year. Short-term capital gains (STCG) are taxed at 15%.

• If the FoF invests in debt mutual funds, then long-term holding, which is more than three years, is taxed at 20% after indexation. Short-term gains depend on the investor’s income tax slab.

• Hybrid FoFs are taxed based on the percentage of equity and debt held in the portfolio. If more than 65% is held in equities, then for taxation purposes, it is treated as an equity mutual fund.

Limitations of Fund of Funds

Although FoFs offer broad diversification, there are some key limitations:

• As discussed above, FoFs can have higher fees due to the double layer of management costs, which may affect the overall return on investment.

• Although diversification helps reduce risk, it can also dilute returns if the underlying funds perform poorly or if there is excessive overlap among the funds.

Things to Consider as an Investor

Before investing in a Fund of Funds, here are some factors to consider:

• Investment Goals: Ensure that the FoF aligns with your stated investment objectives, such as long-term growth, generating income, and diversification.

• Expense Ratio: Compare the charges of various FOFs to get reasonable ones: consider the overall management expense and the various expenses charged under the underlying fund.

Conclusion

Funds of Funds make it easy for investors to get diversification, professional management, and access to specialized funds. Although they have several advantages, such as lower risk and convenient portfolio management, the higher fees and lack of control may not be attractive to some investors. It is essential to balance these factors and understand how a Fund of Funds fits into your overall investment strategy.

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