Fund of Funds (FOFs): Meaning, Types, Advantages, and Disadvantages (2024)

In this article, we will understand the concept of Fund of Funds, understand its workings, advantages, and disadvantages to know if investing in them is a viable option for you or not.

What is a Fund of Funds (FoF)?

Fund of Funds (FoF) or super fund is a type of mutual fund that offers you the convenience and benefits of investing in multiple funds through a single investment. Fund of funds means a type of mutual fund that invests in other mutual funds. So, instead of directly investing in stocks or other instruments, the fund manager invests in a portfolio of various mutual funds.

How Does FoF Work?

Mutual funds invest in different securities, like equity and debt instruments. They invest in a company’s stocks and debt papers on behalf of their investors.
The FoF invests in other mutual funds. Here, the fund manager can invest in a single fund or funds of different fund houses depending on the underlying investment strategy.

Let us take an example of the ICICI Prudential Debt Management Fund (FOF). It invests in its own mutual funds and also funds of different fund houses. As of October 31, 2021, the fund has invested in eight mutual funds, three of which belong to its own fund house.

However, the portfolio of top holdings of funds such as Quantum Equity Fund of Funds (as of October 31, 2021) entirely comprises mutual funds of other fund houses such as Invesco India Midcap Fund, Axis Bluechip Fund, and Mirae Asset Large Cap Fund, etc.

Types of Fund Of Funds (FOFs)

Funds of Funds can differ depending on the fund’s investment objective. Given below are the different kinds of FOFs:

1. Asset Allocator or Multi-Asset Funds

Asset allocator or multi-asset funds invest in different asset classes such as equities, debt, and commodities like gold. For example, FoFs could invest in one mutual fund scheme that invests in stocks, one debt fund scheme that invests in bonds, and one gold fund scheme. It helps you to diversify your investments across different asset classes to earn better returns by minimizing the portfolio risk..

2. International Fund of Funds (FOFs)

International FOFs invest in International Funds, which invest in global companies. In these international FOFs, investors get indirect exposure to large multinational companies without the hassles of opening a trading account with an overseas broker. In addition, global exposure ensures healthy diversification, which ultimately helps in higher returns.

Also, in this case, the fund manager of the FOF can use the expertise of the fund manager of the foreign fund, who would have the expertise of investing in the securities of the specific country.

3. ETF-Based Fund Of Funds (FOFs)

An ETF, or exchange-traded fund, is a marketable security that invests in the basket of investment instruments replicating a broader market index such as NIFTY 50 or BSE SENSEX. ETF-based FOFs invest in the basket of ETFs. This means when you invest in this type of fund, your money gets invested in multiple ETFs. To invest in ETFs, a trading demat account is mandatory.

4. Gold Fund Of Funds (FOFs)

Investors can invest in gold by buying units of gold ETFs. These gold ETFs invest in 99.5% purity gold. Some investors may not invest in Gold ETFs for not having a Demat account. This is where Gold FOFs come into the picture. Gold fund of funds means investing in gold ETFs. For example, ICICI Prudential Regular Gold Savings Fund (FOF) invests in ICICI Prudential Gold ETF.

Advantages Of Fund Of Funds Investing

Now, let’s look at some of the primary advantages of FOFs.

Easy Rebalancing

When it comes to managing your investment portfolio, rebalancing is critical. Rebalancing your portfolio may require that you sell certain investments and buy others. In this case, you may be required to pay capital gains tax if you sell investments.

On the other hand, capital gains tax does not apply to portfolio rebalancing transactions when it is carried out by the different funds that constitute the FoFs. As a result, you can get the benefits of rebalancing while avoiding the tax burden.

Diversification

The biggest advantage of FoFs is that they give access to different mutual funds having varied investment objectives through a single investment.

For example, the ICICI Prudential Asset Allocator fund invests in around 20 different equity and debt schemes of the ICICI Prudential mutual fund. It would have been pretty cumbersome operationally for the investor to invest in these 20 schemes by himself.

The Investment Style Of Different Fund Managers

FOFs invest in multiple mutual funds, whether domestic or international funds. As a result, FOF investors get the advantage of investing in a portfolio that is managed by different fund managers and their research teams.

For instance, International FOF helps you benefit from experts in a specific market segment. Take, for example, the DSP World Mining Fund. It invests in BlackRock Global Funds & World Mining Fund (BGF – WMF) which invests at least 70% of its total assets in equity securities of gold mining businesses. Additionally, it may invest in the equity securities of companies engaged in other precious and base metal mining types.

Convenience In Investing In International Markets And Gold

International FOFs also make it easier to invest in global companies. You don’t have to sign up for a separate account with another intermediary to invest in stocks of multinational companies. You can quickly start investing through international funds. Similarly, gold funds offer an accessible way to invest in paperless gold.

Disadvantages Of Fund Of Funds Investing

Like every good thing has some cons, there are some disadvantages with FoF. Let’s look at some of the drawbacks of FoFs.

Lack Of Flexibility

One major disadvantage of FOF is that investors cannot choose the mutual funds that a fund manager invests in or the investment strategy. If you don’t like one fund, you have no option but to stay invested or redeem your investments if you have already invested.

So, if a fund manager has invested in seven mutual funds, then you automatically get exposure to these seven funds.

For instance, Motilal Oswal Asset Allocation Passive Fund of Funds follows a strategic asset allocation and has limited gold exposure to 10% for Aggressive FoF and Conservative FoF. If you want higher exposure to gold, you can’t get that through this fund. You will have to invest separately.

Higher Expense Ratio

FOFs may have a higher expense ratio at times. The Total Expense Ratio (TER) is the annual charge that fund houses charge to manage the investments. It is calculated as a percentage of the total assets of the fund. SEBI has also segregated the FoFs based on their underlying schemes and has put a cap on the expense ratio that these funds can charge.

For instance, FoFs that invest mainly in the liquid, index, and ETF schemes can charge a maximum of 1%. FoFs that invest primarily in actively managed equity and non-equity schemes can charge up to 2.25% and 2%, respectively.

However, it is seen that a few FOFs have a higher expense ratio than regular schemes because they are responsible for the costs of the underlying schemes in which the FoF has invested.

Let us consider the total expense ratio of two funds– ICICI Prudential Asset Allocator Fund (FOF) and ICICI Prudential Balanced Advantage Fund, that are in the same category.

Data As of November 30, 2021

So, we can see that the total expense ratio of the ICICI Prudential Asset Allocator Fund is higher than the ICICI Prudential Balanced Advantage Fund.

Possibility Of Portfolio Duplication

As FoFs invest in different mutual funds, they may have exposure to the same stock or debt security across multiple funds. This situation will lead to portfolio duplication, which may limit diversification.

Favorable Equity Taxation Not Available

Income tax rules divide mutual funds, including FoFs, into two groups: equity-oriented funds and funds that aren’t equity-oriented funds. Typically, an equity-oriented fund must invest at least 65% of its assets in stocks and other equity-related instruments.

However, the classification criteria for FoFs are slightly different. If FoF invests at least 90% of its money in Exchange Traded Funds (ETFs), which then invests at least 90% of its assets in shares of Indian companies traded on stock exchanges, it is classified as an equity fund. However, even if a FOF invests 100% of its net assets in other equity funds, all other FoFs are taxed as debt schemes or other than equity-oriented schemes.

If FoF is classified as an equity fund, the tax on Short Term Capital Gains(STCG) is 15% on investments sold within one year of investment, and the tax on Long Term Capital Gains (LTCG) is 10% for profits exceeding Rs 1,00,000 and sold after one year of investment.

However, in case a FoF is classified as a debt fund, and if units are redeemed within three years of purchase, the short-term capital gains (STCG) tax is applied. The gains are added to the individual’s income and taxed according to the tax slab of the individual. On the other hand, an LTCG tax of 20% with indexation is applicable for investments sold after three years.

Who should Invest in Fund of Funds?

Funds of funds (FoFs) are well suited to the new or small investor who does not have enough knowledge to manage the portfolio. If you are the one who wants to diversify your portfolio but does not have the expertise to manage your portfolio on your own, then FOFs can be an option.

FoFs allow you to invest in multiple schemes only by investing in one scheme. It helps you to diversify your investments to various asset classes such as equity, debt, gold, etc. Through this fund, you do not have to manage or diversify your portfolio independently; the fund manager will decide on your behalf and allocate the money accordingly.

However, if you have predetermined asset allocation in your mind, then FoF may not be a suitable option. Asset allocation in the FOFs is totally dependent on the fund managers’ decision, which may not fit your desired asset allocation.

Should you invest in a Fund Of Funds?

If you are a newbie investor, the fund of funds category can be a good starting point as it is a basket of different mutual funds that invest in various assets and securities.

Fund of Funds provides access to particular asset classes, such as international companies, that would otherwise be difficult for investors to invest through regular mutual fund schemes. So, if you are an experienced investor, you can diversify your portfolio by investing in international funds.

However, before investing in a FoF, make sure there isn’t a lot of portfolio overlap with the other securities or assets in your portfolio. It is important to make sure that the investments are well-aligned with your risk profile and fit into your overall asset allocation strategy.

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