Fund of Funds

What is a Fund of Funds?

A Fund of Funds (FoF) is a mutual fund scheme that invests in other mutual funds or ETFs rather than directly in stocks, bonds, or other securities. In India, FoF schemes are regulated by the Securities and Exchange Board of India (SEBI) and can invest in units of funds from the same AMC or different AMCs, depending on the scheme’s mandate. This structure is also called multi-manager investing, since investors gain exposure to several fund managers and strategies through a single investment.

FoFs are designed to provide diversification and professional management by spreading investments across asset classes, markets, or strategies. Depending on the scheme’s objective, FoFs may focus on equity (for growth), debt (for stability), or commodities such as gold. Many FoFs offer access to international mutual funds or ETFs for global diversification.

How Does a Fund of Funds Work?

A Fund of Funds (FoF) operates through a two-layer investment structure. Instead of investing directly in stocks, bonds, or other securities, the FoF collects money from investors and channels it into a portfolio of selected mutual funds or ETFs.

The fund manager is responsible for researching markets, screening underlying funds, and constructing a mix that aligns with the FoF’s stated objective. This approach indirectly exposes investors to multiple asset classes, investment styles, and sectors within a single product.

For investors, the structure removes the need to track individual funds separately. They benefit both from the oversight of the FoF manager and from the strategies of the underlying fund managers.

Though exit loads may apply, most FoFs in India are open-ended schemes with daily purchase and redemption. Schemes are available across categories, from conservative debt-oriented FoFs to more aggressive equity or international FoFs, making them adaptable to different risk profiles.

Types of Fund of Funds

FoFs are structured to meet different investment goals. The table below highlights the common types, their focus areas, and the kind of investors they are suitable for:

Advantages of Investing in a Fund of Funds

A Fund of Funds has the following key advantages:

• Diversification and Risk Reduction: Investments are spread across multiple asset classes, sectors, and geographies. This helps cushion the impact of underperformance in any area and promotes more stable returns.

• Access to Specialised and Global Opportunities: FoFs can provide exposure to international markets, commodities such as gold, and specific strategies that individual investors may not easily access.

• Professional Expertise: Experienced fund managers handle fund selection, asset allocation, and rebalancing. Investors indirectly benefit from the FoF manager’s oversight and the strategies of the underlying fund managers.

• Simplified Portfolio Management: Portfolio adjustments and rebalancing are managed within the FoF. This keeps the investment aligned with its objectives without the investor needing to track multiple funds.

• Systematic Investment Options: Many FoFs support SIPs, making it easier to build wealth gradually through disciplined, regular contributions.

Limitations of Fund of Funds

Although FoFs simplify diversification and management, investors should carefully consider the following limitations before investing:

• Higher Costs: FoFs charge expenses at two levels: the fund-of-funds and underlying schemes. This layered cost structure can reduce net returns compared to investing directly in individual funds.

• Tax Treatment: An FoF attains equity-oriented status only when it invests 90% or more in a fund that holds at least 65% in domestic equities. FoFs not meeting this threshold are taxed as debt funds under Section 50AA, often resulting in lower post-tax returns than equity funds.

• Possibility of Over-Diversification: While diversification reduces risk, too much can dilute the impact of outperforming funds and limit potential upside.

• Performance Dependence: Returns rely heavily on the underlying funds and the FoF manager’s selection skills. Poor choices or prolonged underperformance can drag down results.

• Limited Investor Control: Investors cannot directly choose or change the underlying funds. The FoF manager manages the portfolio mix, which may not suit those who prefer more hands-on control.

Things to Consider Before Investing

Before investing in a Fund of Funds, it is important to assess the following factors:

• Investment Objective and Horizon: Understand and align the fund’s objective with your financial goals. FoFs are better suited for medium to long-term wealth creation than short-term gains.

• Expense Ratio and Taxation: Evaluate the total expense ratio, which combines the FoF’s own costs and those of the underlying schemes. For tax purposes, an FoF is considered equity-oriented only if it invests at least 90% of its assets in another fund with a minimum 65% allocation to domestic equities. FoFs not meeting this condition are taxed less favorably, often similar to debt funds under Section 50AA.

• Risk Profile and Diversification: Match the FoF’s risk level with your tolerance. Diversification helps reduce risk but does not eliminate the effect of overall market downturns.

• Performance and Fund Manager’s Expertise: Look at the historical consistency of the FoF as well as the underlying funds. The track record of the FoF manager is also critical since fund selection and asset allocation drive returns.

• Liquidity and Exit Load: Most FoFs are open-ended with daily liquidity. Check for exit loads, as these may apply if you redeem units within a certain period.

How to Invest in a Fund of Funds?

Investing in a Fund of Funds is straightforward and follows a process similar to any mutual fund scheme. The steps are:

• Research and Evaluate Options: Compare FoFs based on their investment objectives, asset mix, historical performance, expense ratio, and risk profile. Select one that aligns with your financial goals.

• Select an Investment Platform: You can invest through an asset management company (AMC), a registered distributor, a bank, or an online investment platform. Choose a trusted channel that offers the FoF you wish to invest in.

• Complete KYC and Open an Account: If you are investing for the first time, complete the mandatory Know Your Customer (KYC) process by submitting identification and address proof. Once verified, your account will be activated.

• Choose the Scheme and Investment Amount: Pick the FoF scheme and decide whether to invest via a lump sum or Systematic Investment Plan (SIP). Ensure you meet the scheme’s minimum investment requirement.

• Make the Investment and Track Performance: Place your order and, once processed, you will receive an account statement or confirmation. You can track your investments online and review performance periodically.

Fund of Funds Tax Implications

The way a Fund of Funds is taxed depends on whether it qualifies as equity-oriented or non-equity, as defined by SEBI and the Income Tax Act. The table below summarises the current rules:

Disclaimer: The above tax treatment is based on the current provisions of the Income Tax Act and recent amendments. Investors should consult a qualified tax advisor or financial planner to understand the exact implications for their personal situation.

Key Takeaways

A Fund of Funds offers investors convenient diversification across asset classes and strategies under professional management. It is most suitable for long-term investors who value simplicity and are comfortable with moderate levels of risk. While FoFs give access to domestic and global opportunities, investors should weigh higher costs and tax rules, particularly whether the scheme is equity-oriented or falls under Section 50AA. With most FoFs being open-ended and available through SIPs, they can build wealth gradually while consolidating the portfolio.

You can start a SIP in the best mutual funds in India if you prefer a simpler entry point into wealth creation.