Fund of Funds (FOFs)

Are you looking for a way to diversify your investments and access a variety of funds with different strategies and asset classes? If yes, then you might want to consider Fund of Funds (FOFs) as an option. FOFs are mutual funds that invest in other mutual funds rather than directly in stocks, bonds, or other securities.

By investing in FOFs, you can benefit from the expertise of multiple fund managers, who select and manage the underlying funds for you. You can also reduce your risk by spreading your money across different funds, which may have different objectives, themes, and styles. FOFs can be of different types, such as multi-asset FOFs, international FOFs, or ETF-based FOFs, depending on the nature and composition of the underlying funds.

In this article, we will explain the concept, advantages, and disadvantages of FOFs, and help you decide if they are suitable for your investment goals.

What is a Fund of Funds?

A Fund of Funds (FoF) is a mutual fund that invests in other mutual funds rather than directly in stocks, bonds, or other securities. A FoF works by selecting and managing a portfolio of underlying funds, which may have different objectives, themes, and styles. A fund of funds (FoF) may take various forms, including multi-asset, international, or ETF-based, contingent on the characteristics and makeup of the underlying funds. A FoF aims to achieve broad diversification and appropriate asset allocation with investments in a variety of fund categories that are all wrapped into one portfolio.

For example, a multi-asset FoF could invest in one mutual fund scheme that invests in stocks, one debt fund scheme that invests in bonds, and one gold fund scheme. This way, the investor can benefit from the expertise of multiple fund managers, who select and manage the underlying funds for them. The investor can also reduce their risk by spreading their money across different asset classes and funds.

Different Kinds of Fund of Funds

There are different types of FOFs, each with its own characteristics and benefits. Some of the common types of FOFs are:

Asset Allocator or Multi-Asset Funds

These are FOFs that invest in a mix of equity, debt, and other asset classes, such as gold, commodities, or real estate. The fund manager decides the proportion of each asset class based on the market conditions and the risk-return profile of the fund. These funds aim to provide a balanced portfolio that can generate growth and income while minimising volatility. Asset allocator funds are suitable for investors who want to diversify their portfolio and have a moderate risk appetite.

International Fund of Funds (FOFs)

These are FOFs that invest in mutual funds that invest in foreign markets. The fund manager selects the funds that have exposure to different countries, regions, or sectors, such as emerging markets, Europe, or technology. These funds aim to provide global diversification and access to high-growth opportunities while hedging against currency fluctuations. International FOFs are suitable for investors who want to explore the potential of foreign markets and have a high risk appetite.

ETF-Based Fund of Funds (FOFs)

These are FOFs that invest in exchange-traded funds (ETFs), which are funds that track the performance of an index, such as Nifty, Sensex, or Nasdaq. The fund manager selects the ETFs that cover different segments of the market, such as large-cap, mid-cap, small-cap, or sectoral. These funds aim to provide low-cost and passive exposure to the market while mirroring the returns of the index. ETF-based FOFs are suitable for investors who want to follow market trends and have a low risk appetite.

Gold Fund of Funds (FOFs)

These are FOFs that invest in mutual funds that invest in gold or gold-related instruments, such as gold ETFs, gold mining companies, or gold futures. The fund manager selects the funds that have exposure to the yellow metal, which is considered a safe-haven asset and a hedge against inflation. These funds aim to provide stability and protection to the portfolio, while benefiting from the appreciation of gold prices. Gold FOFs are suitable for investors who want to diversify their portfolio and have a low to moderate risk appetite.

A Real-World Case of Fund of Funds

One such FoF that has gained popularity among Indian investors is the Motilal Oswal S&P 500 Index Fund of Fund, which was launched in April 2020. This fund invests in the Motilal Oswal S&P 500 Index Fund, which in turn tracks the performance of the S&P 500 Index, a widely followed benchmark of the US stock market.

The Motilal Oswal S&P 500 Index Fund has given a return of 38.5% since its inception, as of January 28, 2024, outperforming the Nifty 50 Index, which has returned 25.6% in the same period. The fund has also outperformed its category average of 28.9%, which consists of other international FoFs.

With the fund, Indian investors can now invest in some of the biggest and most inventive companies in the world, including Tesla, Apple, Microsoft, Amazon, Facebook, and Facebook, all of which are included in the S&P 500 Index. These companies have benefited from the rapid growth of digitalization, e-commerce, cloud computing, social media, and electric vehicles, especially during the COVID-19 pandemic.

The fund has also provided investors with the opportunity to diversify their portfolio across different markets, currencies, and sectors and reduce the risk of concentration in the domestic market. The fund has a low correlation with the Indian market, as the S&P 500 Index has a correlation coefficient of 0.36 with the Nifty 50 Index. This means that the movements of the two indices are not very closely related, and the fund can help reduce the overall volatility of the portfolio.

Compared to the international FoF category average of 1.02%, the fund’s low expense ratio of 0.5% is superior. Additionally, a low minimum investment amount of Rs. 500 makes the fund accessible to a broader range of investors.

Investors with a minimum five-year time horizon and a willingness to assume moderate to high levels of risk should consider this fund. Also, investors who wish to diversify their portfolio across several geographies and take advantage of the US market’s growth potential will find the fund to be ideal.

Because the fund is taxed similarly to a debt fund, gains are subject to 20% gains with indexation benefit if the holding period exceeds three years, and marginal tax rate if it is less than three years. If an investor wants to invest in a fund, they should think about the tax implications.

The fund exemplifies how a fund of funds (FoF) can assist investors in reaping the benefits of low-cost advantages, expert management, and diversification while providing them with exposure to international markets. However, investors should also be aware of the risks involved in investing in international markets, such as currency fluctuations, geopolitical uncertainties, and regulatory changes.

Pros and Cons of Investing in Fund of Funds

A fund of funds (FoF) is a type of investment that pools money from investors and invests it in a portfolio of other funds rather than directly in stocks, bonds, or other securities. FoFs can offer investors the convenience and benefits of diversification, professional management, and access to a variety of themes, geographies, and strategies. However, FoFs also have some disadvantages that investors should be aware of before investing in them. In this article, we will explore the pros and cons of investing in FoFs.

Benefits of Fund of Funds

• Diversification: FoFs can provide investors with exposure to a wide range of asset classes, sectors, markets, and fund managers, reducing the risk of concentration and volatility in their portfolio. FoFs can also help investors achieve their desired asset allocation and rebalance it periodically, without the hassle of buying and selling individual funds.
• Professional management: Fund managers who choose and oversee the underlying funds can provide their knowledge and experience to FoFs. FoFs can also benefit from the due diligence and research conducted by the fund managers on the performance, risk, and fees of the underlying funds. Furthermore, FoFs have access to funds that might otherwise be closed, restricted, or hard to locate for individual investors.
• Access to niche and global opportunities: FoFs can offer investors the opportunity to invest in niche and specialised themes, such as emerging markets, alternative assets, or environmental, social, and governance (ESG) factors, that may not be easily available or accessible through individual funds. By eliminating the need to open foreign accounts or cope with currency fluctuations, FoFs can also assist investors in becoming more aware of international markets and businesses.

Drawbacks of Fund of Funds

• Higher fees: FoFs typically charge higher fees than individual funds, as they incur both the fees of the FoF itself and the fees of the underlying funds. These fees can erode the returns of the FoF and make it harder to outperform the market or its benchmark. Investors should compare the fees and performance of FoFs with similar individual funds or index funds before investing in them.
• Lack of control: Since fund managers choose and allocate the underlying funds, FoFs restrict investors’ ability to choose and manage their portfolio. It might not be possible for investors to tailor their portfolios to suit their tastes, objectives, or level of risk tolerance. Investors may also face the risk of duplication or overlap of the underlying funds, which can reduce the diversification benefits and increase the correlation of the portfolio.
• Tax implications: FoFs may have different tax implications than individual funds, depending on the type, structure, and jurisdiction of the FoF and the underlying funds. Due to their potential for more frequent trading and portfolio rebalancing, funds-in-trust (FoFs) may produce higher capital gains distributions than individual funds. Additionally, if FoFs invest in foreign funds, they might be subject to different tax rates or withholding taxes than individual funds. Prior to investing in FoFs, investors ought to speak with their tax advisors.

In Conclusion

FoFs can be a useful and convenient way for investors to diversify their portfolio, access professional management, and tap into niche and global opportunities. However, investors should also be aware of the risks involved in investing in international markets, such as currency fluctuations, geopolitical uncertainties, and regulatory changes. Investors should also do their own research and consult their financial advisors before investing in any FoF.