Exploring The Wealth Creation Potential of Fund Of Funds

In the alluring world of mutual fund investment, choosing from the myriad of options can be daunting for investors. For those seeking instant diversification and convenience, fund of funds (FoF) emerges as an attractive alternative. But what exactly is a fund of funds, and how can it benefit your portfolio? Let’s explore in this special report
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A fund of funds (FoF) is a type of mutual fund that employs its collective resources to invest in various other types of mutual funds available in the market. Alternatively, this mutual fund also facilitates investment in hedge funds. The portfolios of fund of funds mutual funds entail varying degrees of risk, determined by the manager’s primary objective. If the manager aims to achieve the highest possible yields, the focus will be on mutual funds with higher net asset value (NAV), even though they come with a higher level of risk. 

On the other hand, if stability is the primary goal, low-risk instruments will be acquired using the pool of financial resources. These mutual funds offer the flexibility to invest in both domestic and international funds at the discretion of the asset management company, thereby enhancing the diversification of the fund of funds. A key characteristic of such mutual funds is that they are overseen by highly skilled professional portfolio managers. This domain expertise contributes to accurate market predictions to a certain extent, thereby minimising the likelihood of incurring losses. 

Managing Fund of Funds

Mutual funds allocate their investments across various securities, including both equity and debt instruments. They engage in the purchase of company stocks and debt papers on behalf of their investors. On the other hand, fund of funds directs its investments into other mutual funds. In this context, the fund manager has the flexibility to invest in a single fund or multiple funds from different fund houses, contingent upon the underlying investment strategy. Fund of funds operates as actively managed funds, where the fund manager frequently reallocates underlying funds to capitalise on market fluctuations. 

Unlike passively managed funds, which adhere to a specific allocation model, fund of funds is not passively managed. The scheme primarily encourages investment in affiliated mutual funds overseen by the same expert. While some investments may be directed towards funds managed by unaffiliated advisors, the associated expenses are generally higher than those incurred when investing in affiliated funds. This is due to additional charges for investment management research, resulting in increased costs for the investor engaging with different advisors. 

Types of Fund of Funds

1. Asset Allocation Funds - These funds feature a diverse asset pool, including equity, debt instruments and precious metals. Asset allocation funds aim to generate high returns by capitalising on the best-performing instruments while maintaining a reduced risk level through the inclusion of relatively stable securities in the portfolio.
2. Gold Funds - Gold funds invest in various mutual funds primarily involved in trading gold securities. Depending on the asset management company, fund of funds in this category may have a portfolio of mutual funds or the gold trading companies themselves.
3. International Fund of Funds - The international fund of funds targets mutual funds operating in foreign countries. This strategy allows investors to potentially achieve higher returns by accessing the best-performing stocks and bonds in the respective country.
4. Multi-Manager Fund of Funds - This common type of fund of funds comprises an asset base consisting of various professionally managed mutual funds, each with a different portfolio concentration. Typically, a multimanager fund of funds involves multiple portfolio managers, each handling a specific asset within the mutual fund.
 5. ETF Fund of Funds - Fund of funds with exchangetraded funds (ETFs) in their portfolio is a popular investment tool. Investing in an ETF through a fund of funds is more accessible than a direct investment in the ETF, as the latter requires a demat trading account. However, ETFs, being traded like shares in the stock market, introduce a slightly higher risk factor, making fund of funds in this category more susceptible to market volatility. 
 

Advantages of Fund of Funds

Fund of funds offer investors convenient access to maximise returns not only at the national but also at the international level. The following are some of the advantages associated with these funds:

Expertise of Fund Managers - Professional fund managers, well-versed in various asset classes, oversee fund of funds, leveraging their expertise to maximise investor returns.
Limited Capital Investment - Fund of funds grant investors access to top mutual funds nationally and internationally at a relatively lower investment cost. This accessibility accommodates investors with smaller budgets, allowing them to maximise returns through modest monthly investments.
Diversification - Mutual funds inherently provide diversification benefits and fund of funds enhance this advantage by investing in multiple mutual funds. This approach optimises returns while mitigating risk.
Low Risk of Investment - The diversified portfolio inherent in fund of funds significantly reduces investment risk, making it an attractive option for investors with a low-risk appetite.
Potential for Higher Returns - The combination of professional fund management, diversification and low risk creates the potential for higher returns on investments. Additionally, the lower cost of investment contributes to increased potential returns. 

Limitations of Fund of Funds

While fund of funds offer various advantages, they also come with certain limitations:

1) High Expense Ratio - Due to active management, the expense ratio of fund of funds is higher compared to other investment products such as ETFs. This elevated expense ratio has the potential to diminish investor returns. The total expense ratio (TER) represents the annual charge levied by fund houses for managing investments, calculated as a percentage of the fund’s total assets. SEBI has categorised FoFs based on their underlying schemes and imposed a cap on the allowable expense ratio for these funds. For example, FoFs predominantly invested in liquid, index and ETF schemes are limited to charging a maximum of 1 per cent. FoFs focused on actively managed equity and non-equity schemes can impose expense ratios of up to 2.25 per cent and 2 per cent, respectively. However, it should be noted that certain FOFs may exhibit a higher expense ratio than standard schemes. This discrepancy arises because these FOFs bear the costs associated with the underlying schemes in which they have made investments. 

2) Taxation - The tax structure of fund of funds is complex and can increase the tax liability of investors. Tax in the form of capital gains is levied upon redemption, with varying rates as per the fund’s composition. 

1. For equity-oriented funds, short-term gains are taxed at 15 per cent and long-term gains are exempt up to Rs 100,000, with a 10 per cent tax beyond that threshold.
2. Debt-oriented funds incur short-term gains based on applicable slab rates while long-term gains are taxed at 20 per cent.
3. Hybrid Funds face taxation depending on their majority composition, whether equity-oriented or debt-oriented.
4. dividends received from the fund are also subject to tax in the hands of the investor at applicable slab rates. 

3) Limited Redemption Facility -Fund of funds may have a restricted redemption facility, limiting investors’ ability to redeem their investments in liquid cash as needed. 

Target Audience for Fund of Funds

Fund of funds is particularly suitable for novice or small-scale investors lacking the knowledge to independently manage a portfolio. If you seek portfolio diversification but lack the expertise to handle it on your own, FoFs present a viable option. Investing in a single FoF scheme enables you to access multiple schemes simultaneously. This facilitates diversification across various asset classes like equity, debt, gold, etc 

With FoFs, you need not independently manage or diversify your portfolio. The fund manager assumes this responsibility, making allocation decisions on your behalf. However, if you already have a predetermined asset allocation in mind, FoFs may not align with your preferences. The asset allocation in FoFs relies entirely on the decisions of fund managers, which may not align with your desired distribution of assets. 

Factors to Consider Before Investing

1. Suitability for New Investors - The fund of funds category can be an excellent starting point for new investors, offering a diverse basket of mutual funds that invest in various assets and securities.
2. Access to Specific Asset Classes - Fund of funds provides access to specific asset classes, such as international companies, which may be challenging for investors to access through regular mutual fund schemes. Experienced investors can leverage this to diversify their portfolio with international funds.
3. Portfolio Alignment and Overlap - Before investing in a fund of funds, it’s crucial to ensure there isn’t excessive portfolio overlap with other securities or assets in your existing portfolio. This precaution ensures that investments align with your risk profile and fit into your overall asset allocation strategy.
4. Investment Goals - Clearly define your financial goals and risk tolerance. Align your fund of funds selection with your long-term financial objectives.
5. Track Record and Performance - Analyse the fund of funds historical performance to gauge its consistency and risk profile.
6. Investment Horizon - Consider how long you plan to invest. Fund of funds is suitable for long-term investors as they require time to generate significant returns. 

Conclusion

For investors seeking diversification, professional management and convenience, fund of funds offers a valuable tool for building a robust investment portfolio. By understanding the different types of FoFs available and carefully evaluating their features, investors can make informed investment decisions and achieve their financial goals. However, it is crucial to seek financial advice and conduct thorough research before investing in any FoF, ensuring alignment with your individual circumstances and risk tolerance. Remember, investing comes with inherent risks, and past performance is not a guarantee of future results. Always prioritise responsible and informed decision-making when navigating the investment landscape.

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