What Is A Fund Of Funds? How Does It Work?

Are you curious about “the fund of funds“? Probably, you must have understood a bit through its name.

However, if you are unfamiliar with the term and want to gain sufficient knowledge to help you make an investment decision, read the following article.

Let’s start with the definition and meaning of “the fund of funds” to help you understand the basics.

Fund Of Funds: Meaning & Definition

The fund of funds refers to a portfolio of different investment funds. These funds invest in other funds rather than directly investing in stocks or bonds. This strategy offers exposure to various asset classes and investment styles.

What Types Of Funds Do They Invest In? FOFs may invest in the following types of funds:

1. Mutual Funds
2. Hedge Funds
3. Commodity Funds
4. Exchange Traded Funds (ETFs)
5. Real Estate Funds
6. Index Funds Etc.

Related: Equity Funds | Debt Funds | Hybrid Funds

Characteristics Of the Fund Of Funds

What features of “the fund of funds” make them unique from other investment funds? Let’s discuss:

A. Diversification: The very first feature of these funds is “diversification”. By investing in other funds across various sectors and asset classes, these funds offer a high degree of diversification and spread out the risk.

B. Professional Management: FOFs are managed by professional managers. They intelligently select funds to invest & monitor them. This saves the time and effort of investors.

C. Access To Multiple Expertise: FOFs provide investors with access to the expertise of multiple fund managers across different asset classes and investment styles.

D. Risk Management: FOFs not only intellectually select funds to invest but actively employ risk management techniques such as monitoring fund performance, adjusting allocations based on market conditions, and implementing risk control measures.

Advantages

Fund of funds (FOFs) offer various advantages to investors. Let’s have a quick look.

1. FOFs offer a one-stop solution for investing in multiple funds. This simplifies the investment process, requiring only a single investment decision instead of needing to research and choose individual funds.
2. FOFs can provide access to investment strategies and asset classes that may be difficult or expensive for individual investors to access directly.
3. While FOFs typically charge management fees, these fees may be lower than the combined fees of investing in multiple individual funds.
4. FOFs also save the time and effort for investors to research, monitor and manage individual funds.

Disadvantages

You can’t have only pros. You also have to deal with the cons too. Here below are some possible disadvantages of fund of funds.

1. Due to the layered structure, FOFs typically have higher expense ratios. This is because you pay fees for both the FOF itself (management and operating expenses) and the underlying funds it invests in.
2. You don’t have control over investment decisions. You can’t choose the funds of your choice and have to be completely dependent on fund managers.
3. Despite professional management, FoFs may underperform their benchmarks or individual funds in certain market conditions.
4. While diversification is a key advantage of FoFs, there is a risk of over-diversification, where the portfolio becomes too diluted, resulting in mediocre performance.

Taxation

There are two categories of FOFs for taxation. 1. Equity-oriented and 2. Not equity-oriented.

A. For equity-oriented fund of funds: 1. If you sell your investments before the holding period of one year, a tax of 15% will be deducted on gains on investments. 2. If you sell your investments after the holding period of one year, an LTCG of up to 1 lakh is tax-free. Over this amount, a tax of 10% will be deducted from gains on investments.

B. For not equity-oriented fund of funds: taxes are levied based on the applicable tax slab.

FAQs

Note– This guide is for educational purposes and should not be considered investment advice. Investors should conduct their research before investing in any fund.