Fund of Funds

A Fund of Funds (FoF) is a mutual fund scheme that invests in other mutual funds, not directly in stocks or bonds. Its purpose is to provide investors with diversification across multiple fund houses, asset classes and investment strategies through a single holding. The key goal is simplified portfolio access. Investors get the benefit of professional fund management without the need to manage multiple schemes. But this structure may result in layered expenses, as the FoF’s fees plus the expenses of the underling funds would directly impact net returns. Investors must evaluate whether the diversification benefits justify the higher cost structure relative to direct fund investment.

How Do Fund of Funds Work?

A Fund of Funds (FoF) operates by investing in units of other mutual funds. This approach is known as a multi-manager strategy. The FoF manager selects underlying funds based on their performance and alignment with the scheme’s objective. They review the portfolio regularly and reliable it to maintain target allocations. Investors benefit from diversification across multiple funds and asset classes through a single investment. FoF’s are useful for those who want a broader market exposure but may lack the capital or expertise to build and monitor a portfolio of individual funds. However, returns depend entirely on performance of the underlying funds selected. Also, investors may need to bear the layered costs of operating the fund.

Advantages and Disadvantages of Investing in a Fund of Funds

As FOF funds combine different investment strategies under one structure, their outcomes depend on underlying allocations, making it important to evaluate both benefits and limitations before investing.

Pros

Diversification: This is one of the major strengths of the FOF mutual fund. Since these funds invest in multiple mutual fund schemes rather than individual securities, your investment gets distributed across various sectors, asset classes and fund management styles. This minimises the risk of having a dependence on the performance of a single fund or section of the market. Diversification helps spread the volatility of long term investment durations and ride market cycles since the losses of one segment can be countered with profits of another.

Convenience: FOF funds simplify the investment process for individuals who may not have the time or expertise to track several mutual funds. Instead of researching and managing multiple schemes, you gain exposure to a diversified portfolio through a single investment vehicle. Professional fund managers assist in fund selection, rebalancing and tracking. This allows participation in various markets while keeping the investment process streamlined,

Cons

High Expense Ratio: One of the most common shortcomings of FOF funds is a higher rate of costs. Investors may indirectly bear two layers of costs – the expense ratio charged by the FoF itself and the expense ratios of the underlying mutual funds in which it invests. The FoF expense ratio covers fund management, administration, and operational costs, while the underlying funds also charge their own fees for portfolio management and operations. These extra charges may have a slight impact on net returns in the long term, especially if performance differences between funds are minimal.

Lack of Flexibility: FOF funds do not provide much control over the choice of the funds. Investors cannot alter or substitute the underlying schemes in the portfolio because such policies are solely in the hands of the fund manager. It may not be appropriate for those who want to have a more active approach to investment or a more personalised allocation of investments based on personal opinions of the market.

Who Should Invest in Fund of Funds?

FOF mutual funds suit investors who prefer diversification without the need to build and manage underlying funds in the portfolio. This would allow the FOF to be accessible for different types of investors, based on their wealth goals and market sophistication.

1. New or First-Time Investors

FoFs can be appropriate for beginners because they simplify diversification. Rather than doing research and monitoring several funds individually, you can have access to a larger portfolio with a single scheme. This makes the process of construction and monitoring of a portfolio less complex.

2. Investors with Limited Capital

FoFs attract investors who seek exposure to various types of funds but do not have enough capital to invest in the different schemes separately. A diversified allocation pools investments into different mutual funds into a single investment portfolio.

3. People Without Proper Market Knowledge

Not every investor has the time or knowledge to track fund performance, asset allocation, or sector trends. Professional fund managers handle selection and monitoring of underlying funds, ensuring portfolio management aligns with the scheme’s investment strategy. This can help investors invest in markets without having to do the research themselves.

4. Long-Term Investors

FoFs can suit long-term investment strategies when paired with disciplined investment approaches such as Systematic Investment Plans (SIPs). By spreading exposure across multiple funds, FoFs may help manage volatility over time and support wealth creation through diversified allocation

How to Invest in a Fund of Funds?

An online investment platform like HDFC SKY makes investing in FOF funds a simple and organised process. You can begin your investing journey easily by following a few basic steps:

1. Research Thoroughly

Firstly, you should analyse the various types of FOF funds available on the platform. Review their investment purpose, past performance, cost ratio and risk profile. This move will assist you to determining a scheme that suits your financial objectives and investment time frame.

2. Choose the Investment Platform

You can choose an online platform like HDFC SKY, in which you will be able to research, compare and invest in various types of mutual funds, such as FOF funds. Choosing a reputable and controlled platform guarantees a safe transaction and clear reporting.

3. Open and Complete Your Account Setup

You need to open a Demat or investment account through the HDFC SKY mobile app or website. As part of the process, you will be required to complete the KYC formalities by submitting your PAN, Aadhaar, and bank details for verification.

4. Select the Appropriate Fund

Once your account is active, you need to go to the mutual fund section and find appropriate FOF funds. Compare plans in terms of diversification strategy, asset allocation and consistency of performance.

5. Start Investing

After selecting a scheme, decide whether you wish to invest through a lump sum or a Systematic Investment Plan (SIP). Complete the payment through UPI, net banking or other available options. You can later monitor performance, modify SIPs or redeem units directly from your dashboard.

Factors to Consider While Investing in the Fund of Funds

It is always good to consider a few key factors before investing in a Fund of Funds that might determine how suitable the scheme is for financial planning. Reviewing these points allows you to know the cost structures, quality diversification and overall suitability with your investment goals.

• Expense Ratio- Verify the overall expense, which includes the fee of the underlying funds.
• Portfolio Duplication- Make sure that the FoF is diversifying and not making repeated exposures.
• Tax Efficiency- Know how the fund is taxed and how it will fit into your overall financial strategy.
• Investment Horizon- Most equity FoFs are generally more suitable for long-term goals, while others, like debt or gold FoFs, may suit different time horizons. Align your fund strategy with your intended investment horizon.
• Objective Alignment- Ensure that the objective of the FoF is in line with your risk appetite and returns expectations.

Taxation on Fund of Funds

Taxation on Fund of Funds (FoF) is different from other mutual fund types. If the FoF invests a minimum of 90% of its money in Exchange Traded Funds (ETFs), which in turn invests a minimum of 90% of its assets in Indian companies traded on the stock exchange, then it is categorised as an equity fund and taxed accordingly. All other FOFs are classified as debt funds for taxation purposes.

1. Taxation on equity funds 

• – Short-term capital gains tax: Applicable on funds sold within 12 months. Tax rate is 20% (plus cess/surcharge)
• – Long-term capital gains tax: Applicable on funds sold after being held for more than 12 months. Tax rate is 12.5% on gains exceeding 1.25 lakhs in a financial year.

2. Taxation on debt funds

• For debt-oriented funds (where investments are made on or after April 1, 2023), any capital gains, whether short-term or long-term, are taxed at the investor’s applicable income tax slab rate.
• For investments made before April 2023, long-term capital gains are taxed at 12.5% without indexation benefit, while short-term capital gains are taxed as per ther investor’s income tax slab rates.

Conclusion

Fund of funds offer diversified exposure across multiple mutual fund schemes through a single investment. It can support portfolio balance by spreading exposure across strategies and markets. Investors benefit from simplified portfolio construction with professional monitoring. They need to assess cost structures, underlying fund quality and alignment with their investment horizon before committing capital for FoF. This fund works best as a part of long-term, displaced allocation strategy.