What is a Fund of Funds in Indian Mutual Markets

A Fund of Funds (FoF) is a mutual fund that invests in other mutual funds rather than directly in stocks, bonds, or other securities. This type of investment structure allows investors to gain exposure to a diversified portfolio managed by multiple fund managers, each specializing in different asset classes or strategies. In the Indian share market, a Fund of Funds can invest in equity, debt, gold, or even international funds, offering investors the benefit of multi-layer diversification.

Key Features of Fund of Funds:

Diversification: Since a Fund of Funds holds multiple underlying funds, investors gain access to a diversified mix of assets.
Professional Management: Each underlying fund is managed by professional fund managers, increasing the expertise involved in handling investments.
Risk Mitigation: By investing in multiple funds, FoFs spread the risk across different asset classes, strategies, and fund managers.
Higher Expense Ratio: FoFs often come with higher expense ratios compared to traditional mutual funds because investors pay fees at both the FoF level and the underlying fund level.
Simplicity for Investors: Investors can access a diversified portfolio through a single investment vehicle, simplifying the process of investing across different funds and asset classes.

Types of Fund of Funds

There are several categories of FoFs in the Indian share market based on their investment objectives:

1. Equity Fund of Funds:

These funds invest in a mix of equity mutual funds. They focus on generating capital appreciation by investing in funds that hold stocks of various companies. Equity FoFs aim to create wealth over the long term by tapping into the potential of multiple equity mutual funds.

Risk Level: High
Ideal for: Long-term investors with a high-risk appetite.

2. Debt Fund of Funds:

Debt FoFs invest in a basket of debt mutual funds. These funds focus on preserving capital and generating stable returns through investments in bonds, government securities, and other fixed-income instruments.

Risk Level: Moderate to Low
Ideal for: Conservative investors seeking stable income.

3. Hybrid Fund of Funds:

Hybrid FoFs invest in a mix of equity and debt mutual funds, balancing the risk between capital appreciation and income generation. This type of FoF is ideal for investors seeking a moderate-risk option that provides both growth and income.

Risk Level: Moderate
Ideal for: Investors with a balanced risk appetite.

4. International Fund of Funds:

International FoFs invest in mutual funds that hold foreign stocks or bonds. These funds provide Indian investors with exposure to global markets, allowing them to diversify beyond the domestic economy.

Risk Level: High (due to currency fluctuations and geopolitical risks)
Ideal for: Investors seeking global diversification.

5. Gold Fund of Funds:

These funds invest in gold ETFs (Exchange Traded Funds) and provide exposure to the price movements of gold. They are ideal for investors looking to hedge against inflation or economic uncertainty.

Risk Level: Moderate
Ideal for: Investors seeking safe-haven assets or inflation protection.

How Do Fund of Funds Work?

Fund of Funds operate by pooling money from investors and allocating it across different underlying mutual funds. Each of these funds has its own investment strategy, and the FoF aims to combine them to achieve the desired level of diversification and risk management.

For instance, an equity FoF might invest in multiple mutual funds that focus on different sectors, such as technology, pharmaceuticals, and infrastructure. This spreads the risk across various industries, reducing the impact of poor performance in any single sector.

The performance of a Fund of Funds depends on the collective performance of its underlying funds. The fund manager is responsible for selecting and managing the portfolio of mutual funds to ensure that it aligns with the FoF’s investment objective.

Example:

Let’s take an example of a hypothetical equity FoF that invests in three mutual funds:

Fund Name	Allocation (%)	1-Year Return (%)
ABC Equity Fund	40%	12.50%
XYZ Midcap Fund	35%	10.75%
PQR Smallcap Fund	25%	15.00%

In this example, the overall return of the FoF is calculated based on the weighted returns of the underlying funds:

ABC Equity Fund contributes 40% * 12.50% = 5.00%
XYZ Midcap Fund contributes 35% * 10.75% = 3.76%
PQR Smallcap Fund contributes 25% * 15.00% = 3.75%

Thus, the overall return of the FoF is 5.00% + 3.76% + 3.75% = 12.51% for the year.

Historical Performance of Fund of Funds

Let’s explore the historical performance of Fund of Funds in India across different categories:

Year	Equity FoF Average Return (%)	Debt FoF Average Return (%)	Hybrid FoF Return (%)
2018	8.24%	7.45%	6.89%
2019	12.45%	9.32%	10.58%
2020	7.89%	6.45%	9.12%
2021	18.34%	5.32%	12.78%
2022 YTD	9.12%	6.24%	7.23%

As shown in the table, Equity FoFs tend to offer higher returns compared to Debt and Hybrid FoFs. However, they also come with higher risk, making them more suitable for long-term investors with a higher risk appetite.

Benefits of Fund of Funds

1. Diversification:

A Fund of Funds allows investors to access a wide variety of assets and investment strategies through a single investment. This helps spread risk and reduces the impact of any one investment performing poorly.

2. Professional Management:

Each underlying fund in a FoF is managed by a professional fund manager. This means investors benefit from the expertise of multiple fund managers, each specializing in their respective fields.

3. Lower Investment Threshold:

FoFs provide retail investors with access to diversified portfolios without requiring a large upfront investment. This makes it easier for small investors to gain exposure to multiple asset classes.

4. Hassle-Free Investment:

Investing in a Fund of Funds is a simple way to diversify without the need to manage multiple mutual fund accounts. The fund manager takes care of asset allocation, making it a hands-off investment for investors.

5. Access to Global Markets:

International FoFs allow Indian investors to diversify their portfolios beyond domestic markets, gaining exposure to global companies and industries.

Risks Involved in Fund of Funds

While Fund of Funds offer several benefits, they also come with their own set of risks:

1. Higher Expense Ratios:

Since FoFs invest in other mutual funds, investors are essentially paying fees at two levels: the FoF itself and the underlying funds. This can lead to higher overall expenses, which can eat into returns over time.

2. Duplication of Holdings:

Some FoFs may invest in multiple funds that have overlapping holdings, reducing the diversification benefit. For example, two underlying funds might both hold large positions in the same stock, increasing exposure to that stock.

3. Performance Risk:

The performance of a Fund of Funds depends on the collective performance of its underlying funds. If one or more of these funds underperform, it could drag down the overall return of the FoF.

4. Liquidity Risk:

Certain types of FoFs, such as those investing in international or sector-specific funds, may face liquidity issues if the underlying funds are not easily tradable. This could impact the FoF’s ability to meet redemption requests.

Who Should Invest in Fund of Funds?

Fund of Funds are suitable for a wide range of investors:

New Investors: FoFs are ideal for new investors who want exposure to a diversified portfolio without the complexity of managing multiple investments.
Conservative Investors: Debt or Hybrid FoFs offer a low-risk option for conservative investors seeking stable returns with a moderate level of risk.
Aggressive Investors: Equity or International FoFs are suitable for aggressive investors looking to capture higher returns by investing in multiple equity or global funds.
Long-Term Investors: Investors with a long-term horizon can benefit from the compounding effect of diversified investments held in FoFs.

Comparison: Fund of Funds vs Traditional Mutual Funds

Let’s compare Fund of Funds with traditional mutual funds to understand the key differences:

Feature	Fund of Funds	Traditional Mutual Funds
Investment	Invests in multiple mutual funds	Invests directly in securities
Diversification	High	Depends on the fund type
Expense Ratio	Higher (fees at two levels)	Lower (single-layer fees)
Risk	Lower due to diversification	Varies based on the type of fund
Suitable for	Investors seeking multi-asset exposure	Investors with specific asset preference

As shown, FoFs provide greater diversification, making them less risky overall but with higher costs due to double-layered fees. Traditional mutual funds, on the other hand, might offer more targeted exposure at a lower cost.

Taxation of Fund of Funds in India

The taxation of FoFs in India depends on the type of underlying funds they invest in:

Equity FoFs: If the underlying funds are equity-oriented, the FoF will be taxed as an equity mutual fund. Short-term capital gains (STCG) are taxed at 15%, while long-term capital gains (LTCG) above INR 1 lakh are taxed at 10%.
Debt FoFs: If the underlying funds are debt-oriented, the FoF will be taxed as a debt mutual fund. STCG is taxed as per the investor’s income tax slab, while LTCG is taxed at 20% with indexation benefits.

Investors should consider their tax liabilities when investing in FoFs, as taxation can impact the overall returns.

Conclusion: Should You Invest in Fund of Funds?

Fund of Funds can be an excellent investment option for investors looking for a hassle-free, diversified portfolio. They provide access to multiple mutual funds, each with its own investment strategy, offering a well-rounded exposure to various asset classes. However, investors should be aware of the higher fees and the potential for overlapping holdings.

FoFs are suitable for both conservative and aggressive investors, depending on the type of FoF chosen. Whether you’re a new investor looking for a simple way to diversify or a seasoned investor seeking exposure to multiple asset classes, a Fund of Funds could be a valuable addition to your portfolio.