Investing can be intimidating, particularly when dealing with various fund choices. A Fund of Funds (FOF) streamlines this by providing diversified investments in different mutual funds to lower risk while maximising returns. Whether you are new to investing or a seasoned investor seeking professional management, FOFs offer a systematic method for portfolio construction.
Yet, how are they different from traditional mutual funds? Are they tax-advantaged? Do they charge higher fees? Continue reading as we demystify all you need to know about Fund of Funds!
What is Fund of Funds (FOF)?
A Fund of Funds is an investment approach, where a portfolio comprises several investment funds instead of owning stocks, bonds, or securities directly. Under this framework, an FOF invests mostly in units of other mutual fund schemes, which is referred to as a multi-manager investment.
Diversification is one of the main features of a FOF since it distributes investments across several funds, lowering the risk. Moreover, investors can access other asset classes, making it favourable for small investors or individuals with no direct experience in choosing individual fund managers.
On taxation, in Section 112A of the Income Tax Act, a FOF is treated as equity-oriented if it puts a minimum of 90% in an equity-oriented mutual fund, which also has 90% assets under domestic equities. It will be taxed like a non-equity-oriented fund otherwise. Therefore, FOFs offer an easy and diversified way of investment, suitable to a wide majority of investors.
How Does FOF Operate?
A fund of fund meaning includes a money pool investment vehicle where money from investors is collected and invested in various mutual fund schemes. For example, ETFs, hedge funds, index funds, sectoral funds, and thematic funds. Unlike conventional mutual funds, a FOF does not directly invest in stocks, bonds, or any other security.
For example, consider an investor owning five mutual funds:
- Fund A – a sectoral mutual fund
- Fund B – a property fund
- Fund C – a theme fund
- Fund D – an Exchange-Traded Fund (ETF)
- Fund E – an index fund
It is difficult to track the performance of each fund individually. A FOF streamlines this by managing the investment through these funds professionally, benefiting from the skill of several fund managers. Therefore, these funds work based on two principal strategies of investment:
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Diversification
FOFs minimise aggregate risk by making investments in a portfolio of mutual funds having different strategies. They provide a twofold layer of diversification by investing in diversified funds and making sure the individual funds are invested in diversified securities. Hence, this method evens out the risk without drastically sacrificing returns.
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Asset Allocation
FOFs maximise the reward-risk ratio by diversifying investments between high-risk equity funds and other asset classes. Moreover, they offer exposure to highly specialised funds that may not be accessible to individual investors, generating consistent long-term growth.
In short, asset allocation through FOFs offers diversified, professionally managed, and structured investment, which is perfect for those seeking stability with moderate returns at low involvement.
Different Types of FOF
Fund of Funds are available in different types, suiting specific investment goals. The following are the major types of funds:
1. Asset Allocation Fund of Fund
Asset allocation funds invest in a combination of asset classes, such as equity, debt instruments, and precious metals. Such a diversified portfolio enables investors to take advantage of high-performing assets while limiting risks with stable investments.
2. Gold Fund of Fund
Gold FOFs invest in mutual funds dealing mainly in gold securities. Depending on the asset management company, they also hold interests in gold trading firms. So, investors can gain exposure to gold without actually buying the metal through these funds.
3. International Fund of Fund
This segment deals with foreign mutual funds. Investors gain from international diversification and potentially high returns by investing in leading stocks and bonds of various economies.
4. Multi-Manager Fund of Fund
Probably the most widely used type, these funds invest in several professionally managed mutual funds, each pursuing a different investment approach. Additionally, they have several portfolio managers who manage them for a diverse and balanced investment style.
5. ETF Fund of Funds
Funds are invested in Exchange-Traded Funds (ETFs) so that ETF investment becomes available without the need to have a demat trading account. Therefore, with ETFs being traded like stocks, they are exposed to market risk and so are marginally riskier than a conventional basket of funds.
Key Benefits of Investing in a FOF
Investing in a Fund of Funds has various advantages, which make it a popular choice among investors looking for diversification, professional management, and convenience of investment. Here are the major benefits of fund of funds:
1. Convenient Portfolio Rebalancing
One of the most significant fund of funds advantages is that rebalancing portfolios is very easy. In a regular investment, rebalancing requires selling certain assets and buying others, and this could be subject to capital gains tax. However, within a FOF, rebalancing takes place at the fund level without imposing any tax on individual investors while continuing to optimise asset allocation.
For instance, if an investor has distinct equity and debt funds, they would need to sell and purchase assets manually in a ratio of 60:40, which may attract capital gains tax. In a FOF, a fund manager realigns investments internally to maintain the best balance without subjecting investors to tax charges.
2. Diversification Across Several Funds
FOFs offer exposure to a range of mutual funds with varying investment styles, asset classes, and risk profiles. Rather than choosing several funds individually, investors can diversify their investments with one single investment. For example, the ICICI Prudential Asset Allocator Fund invests in 20 various equity and debt schemes, relieving investors from dealing with several investments individually.
3. Professional Fund Management
Since FOFs invest in several mutual funds, they enjoy expertise in various fund managers and research groups. This provides active watchfulness, strategic fund choice, and dynamic portfolio rebalancing across market scenarios.
For instance, the international Fund of Funds enables investors to access expert fund managers in overseas markets. The DSP World Mining Fund, for instance, invests in the BlackRock Global Funds & World Mining Fund, which includes gold and metal mining shares. Moreover, this provides investors with access to specialist markets that they may not be able to tap into on their own.
4. Easy Access to International and Gold Investments
Foreign investment generally involves opening foreign brokers’ accounts, which may be time-consuming and complicated. Global FOFs eliminate this hassle by providing an avenue to access global markets from domestic platforms. The same applies to gold funds, which facilitate investment in gold stocks with ease, without the time and effort required to buy and store physical gold.
For instance, an Indian investor seeking exposure to international markets may invest in the Edelweiss Greater China Equity Offshore Fund, gaining access to leading Chinese corporations without opening a foreign brokerage account.
5. Risk Mitigation and Stability
FOFs minimise investment risk by diversifying holdings in several funds and asset classes. Even in the event of a poor performance by one fund, the overall portfolio will be stable because of its diversification. Hence, this disciplined method of investing lessens the influence of market volatility and provides smoother long-term returns.
Potential Drawbacks of a FOF Investment
Though Fund of Funds have several benefits, it has some disadvantages too that need to be taken into consideration by investors before investing. Here are the potential drawbacks of a FOF investment:
1. Inflexibility
The greatest drawback of FOFs is that investors do not have any say in selecting individual mutual funds or investment strategies. The fund manager chooses which funds to include, and investors abide by the allocation.
2. Increased Expense Ratio
This basket of funds tends to have increased costs because of the layering. The investors incur the expense ratio of the FOF and the underlying mutual funds.
3. Risk of Portfolio Duplication
These funds are invested in a series of mutual funds, and certain funds might invest in similar stocks or securities. This may lead to portfolio duplication, diminishing the benefits of diversification.
4. Over-Diversification Risk
Though diversification aids in reducing risk, excessive diversification reduces returns. When a FOF invests in too many funds, the collective effect of top-performing funds is diluted, reducing the possibility of achieving large gains.
5. Fund Manager’s Performance Dependency
A FOF‘s success relies to a great extent on the fund manager’s choice of underlying funds. If the selected funds do not perform well, the returns to the investor will be negatively impacted, irrespective of general market trends.
Who Should Consider Investing in a FOF?
Fund of Funds are investment products that invest money in a diversified mutual fund portfolio to maximise return with minimum risk. Moreover, investors with limited financial capacity can diversify their investments without committing a large sum of money.
Here are the ideal candidates for FOF investments:
1. Limited Capital Investors
These groups of funds allow those with limited investments to tap into a large pool of mutual funds, including those of high value that may otherwise necessitate large capital. Therefore, it opens up investment avenues to more people, enabling them to diversify their portfolios.
2. Investors Looking for Diversification
FOFs provide inherent diversification through investment in mutual schemes within different asset classes and industries. This helps to reduce risk since the performance of one fund does not make a significant contribution to the overall portfolio.
3. Investors with Limited Expertise or Time
Monitoring a diversified portfolio needs to be done consistently, and it needs expertise. Additionally, professional fund managers take care of asset allocation and fund selection in FOFs, which is best for investors who do not want to get involved in handling the portfolio themselves.
4. Long-Term Investors
These funds are best for people who can keep their money locked up for a long time as diversification benefits and professional management skills will take a long time to be realised.
Real-World Examples of FOF
Fund of Funds are an important part of the investment industry, providing diversified exposure to various asset classes and investment strategies. Blackstone Alternative Asset Management (BAAM), Goldman Sachs Asset Management (GSAM), and HarbourVest Partners are some of the largest and most powerful FoFs. These companies illustrate how FoFs function on a large scale and serve institutional and high-net-worth investors.
1. Blackstone Alternative Asset Management (BAAM)
BAAM is a hedge fund investment leader, overseeing diversified portfolios across various hedge fund strategies. These strategies can include quantitative trading models, event-driven investments, and global macroeconomic trend-based trading. Moreover, BAAM’s structured strategy enables investors to gain exposure to hedge funds without the direct selection of individual funds.
2. Goldman Sachs Asset Management (GSAM)
GSAM’s Multi-Manager Alternatives Fund is a popular FoF that invests investor capital in a variety of alternative investment strategies, including:
- Investors invest in distressed debt, which funds companies with turnaround potential.
- Equity long-short investors buy undervalued stocks and sell overvalued stocks to generate returns in various market conditions.
- Tactical traders use dynamic asset allocation to exploit short-term market inefficiencies.
- As of June 2018, GSAM had assets under management of over $1 trillion, highlighting the enormous size at which FoFs can operate.
3. HarbourVest Partners
HarbourVest specialises in private equity fund of funds, putting money in technology start-ups, healthcare companies, and manufacturing companies via venture capital and growth equity funds. It also puts money in buyout funds, buying established firms, and mezzanine funds, providing subordinated debt with equity-linked features. These practical illustrations demonstrate the diversification and size of these funds, placing them on top of investment platforms in worldwide markets.
Final Thoughts
Summing up, Fund of Funds presents a clever, diversified investment strategy, so they are perfect for investors looking for professional guidance and lower risk. Although they are more expensive and may over-diversify, their advantages usually surpass the disadvantages. Whether you are new to investing or an experienced investor, FOFs can be a great addition to your portfolio. This will help you diversify your investment and dilute your financial risks.
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