Fund of funds: A guide to understanding and investing in this scheme

Investing directly in stocks may not suit all investor risk appetites and managing multiple mutual funds might be complicated at times. 

This is where a fund of funds comes into the picture. These specialised mutual funds aggregate capital from investors and allocate it across high-performing mutual fund schemes. 

That said, let’s discuss what a fund of funds is, its types and its benefits in-depth. Let’s begin!

What is a fund of funds (FoF)?

Simply put, a fund of funds is a specific kind of mutual fund that puts money in other mutual funds. Here, a fund manager’s investment strategy often involves purchasing shares in many mutual funds rather than buying individual stocks or other assets. Investors can also invest in hedge funds through a FoF.

In FoF, the investment approach dictates whether the fund manager invests in just one fund or several funds from multiple fund houses. Asset managers might invest these mutual funds in domestic or foreign funds. This flexibility allows the fund of funds to be more diversified.

Fund of funds example

The ICICI Prudential Debt Management Fund (FOF) is a good example of a FoF. Among its investment vehicles are its mutual funds and those of other fund houses. The fund invested in 8 mutual funds as of October 31, 2021. 

Types of fund of funds mutual funds

• Multi-asset funds

A multi-asset fund, sometimes known as an asset allocator, may hold different assets, including equities, bonds, commodities, and more. A FoF may invest in an equity mutual fund, a bond fund, or a gold fund, among other investment options. 

By spreading your investments among several asset classes, you may reduce your portfolio’s overall risk and increase your potential return. 

An example of such funds would be the ICICI Prudential Passive Multi-Asset FoF, which has an asset allocation of 63.42% equity, 13.15% debt, 8.88% commodities, and 14.55% cash and cash equivalents. 

• International fund of funds

These funds invest in international funds, which make investments in multinational corporations. Investors can gain indirect exposure to major global corporations through these funds without having to deal with the difficulties of registering a trading account with a foreign broker. 

On top of that, being exposed to different markets worldwide helps with diversity, which leads to better profits.

In this situation, the fund management can also tap into the knowledge of the foreign fund’s manager, who is highly qualified to invest in that country’s stock market.

For example, Edelweiss US Technology Equity FoF – Direct Plan can be mentioned here, which has an asset allocation of 100.13% equity, 0.43% debt, and -0.56% cash and cash equivalents.

• Multi-manager fund of funds

In this type of vehicle, the assets are pooled from several different professionally managed mutual funds with varying portfolio concentrations. A multi-manager fund of funds can have several different managers in charge of the fund.

Aditya Birla Sun Life Active Debt Multi-Manager FoF Scheme – Regular Plan would be one example of such funds. The asset allocation of this fund is 39.58% equity, 0.02% debt, and 6.4% cash and cash equivalents. 

• ETF fund of funds

A popular way to invest is through a fund of funds, which holds exchange-traded funds. Compared to investing directly in an ETF, investing in a fund of funds makes this product more accessible. 

The reason behind this is that investing in ETFs may require a demat trading account, unlike investing in ETF funds of funds.

However, ETFs are more vulnerable to market volatility than other types of funds since they are traded like equities in the stock market. 

One example of an ETF FoF would be Axis Equity ETFs FoF – Direct Plan, which has an asset allocation of 97.22% equity, 2.84% debt, and -0.06% cash and cash equivalents. 

Benefits of investing in a fund of funds scheme

1. Diversification

A fund of funds invests in many top-performing mutual funds, each of which focuses on a different asset class or industry. The diversity of the underlying portfolios optimises both returns and risks, ensuring profits through diversification.

2. Expert fund manager

Professionals with extensive knowledge and experience oversee the fund of funds. Complex investment strategies put in place by such portfolio managers through thorough research and precise market forecasts guarantee high returns.

3. Low capital requirements

With the right funds, even with limited funds, one can invest and increase their profits. The option to invest in a fund of funds with a monthly investment scheme is also available.

4. Rebalancing

Maintaining a well-managed financial portfolio requires regular rebalancing. If you want to rebalance your portfolio, you might have to sell some investments and buy alternatives. If this is the case, selling investments can make you liable for capital gains tax.

However, when the various mutual funds that make up the FoFs complete a portfolio rebalancing transaction, it is exempt from capital gains tax. It is only subject to taxation when you redeem the units from the fund. As a result, you can reap the rewards of rebalancing without worrying about paying taxes.

Conclusion

As a beginner trader, the fund of funds group might be a good place to start. This is because FoFs involve a variety of mutual funds that invest in diverse assets and stocks.

Investors may have access to asset classes, such as foreign corporations, that aren’t typically available via traditional mutual fund schemes using a fund of funds.

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