The Fund of Funds (FoF) 101
Your mutual fund portfolio should have a mix of different types of funds, depending on your risk tolerance, investment goals, and how long you have to reach your goal.
Diversification, which is a basic principle of investing, also requires that you invest in more than one type of fund. Adding a Fund of Funds to your portfolio is one way to diversify.
Let’s look at how a Fund for Funds works and what you should think about if you want to invest in one.
Fund for Funds Schemes
The Fund of Funds (FoF) scheme is a mutual fund scheme that invests the pooled resources in other schemes from the same fund house or from different fund houses, depending on the investment mandate.
So, by investing in one fund, you get the benefits of investing in multiple funds.
Depending on its investment mandate, a FoF scheme may invest in domestic funds (funds in their home country) and/or offshore schemes (also called international fund of funds).
Instead of stocks, bonds, and money market instruments, a FoF’s portfolio could be made up of different types of mutual fund schemes.
By putting your money into this one fund, you can get access to several different mutual fund schemes run by different fund managers.
The rules say that a FoF scheme must invest at least 95% of its total assets in the fund or funds that it is based on.
Mutual fund companies offer different kinds of FoFs, such as Equity Fund of Funds, Multi-manager Fund of Funds, Asset Allocation Fund of Funds (also called Multi-Asset Fund of Funds), Global Fund of Funds, Life Stage or Managed Solutions Fund of Funds (for people of different ages who want to plan their finances), Debt Fund of Funds, Gold Funds (which invest in an underlying gold ETF), etc.
A FoF scheme has these benefits:
Even if you only put in a small amount, you might be able to get the benefits of optimal diversification.
You get to take advantage of the different investment styles and strategies used by fund managers of the mutual funds that make up the FoF. It makes it easier to keep track of multiple accounts/folios and investments.
This makes it easy to review and keep track of your portfolio, and it keeps you from having too many investments.
For retail investors, a FoF may be the only way to invest in certain international opportunities or themes.
Since you only invest in one fund instead of several, the transaction costs are lower.
It makes the tax impact of rebalancing the portfolio less severe.
If, for example, you took a scheme out of your portfolio because it wasn’t doing well and put the money into another scheme, you would have to pay the appropriate tax.
But when the fund manager moves money from one fund to another in a FoF, the investor doesn’t have to pay taxes.
However, there are a few downsides.
Higher expense ratio: Depending on the type of FoF scheme, the expense ratio may be higher. This is because the costs are actually paid at two levels:
1) by the Fund of Funds, and
2) by the investment schemes that make up the Fund of Funds.
Mutual funds have different tax rules:
For tax purposes, a FOF could be focused on equity or on debt. For a FOF to be taxed as an equity-oriented fund, it must invest at least 90% of its assets in the units of another Exchange Traded Fund, which in turn must invest at least 90% of its assets in the equity shares of listed domestic companies.
Who should put money into FoF?
You could use a FoF scheme if you want a varied investment portfolio that isn’t too hard to understand, you only have a small amount to invest, and you want to get the most out of different ways to manage funds.
Choose the FoF scheme(s) by looking at the investment mandate, its past performance, and how well it fits your needs.
