Sharekhan Blog

What are Fund Of Funds?

  • Apr 17, 2024

The best part is that you don't have to worry about choosing the right mutual funds, as the fund managers will do it for you by regularly selecting the best combinations.

But here's the catch: these products come with a relatively higher cost structure. So, before investing in them, it's important to evaluate the benefits against the costs sustainably. This article examines key aspects of concepts, types, pros, cons, and considerations required for making informed allocation decisions.

Fund of Funds Definition

The definition of fund of funds constitutes specialised portfolio investment products that allow simplified participation across an array of mutual fund schemes through a main structure. A FOF provides diversification and asset allocation across various fund managers and asset classes.

The purpose of a FOF is to simplify investing and achieve broad diversification using just one fund. It allows investors to reduce risk through diversification and asset allocation without assembling their portfolios themselves. A FOF enables partaking in investments that may otherwise be inaccessible for smaller investors.

Types of Fund of Funds

The following comprises the best fund of funds list in the country :

1. Asset Allocation Funds

Asset Allocation Funds of Funds (FOFs) invest in a mix of asset classes to optimise returns at a defined risk tolerance. With prudent asset allocation, even small investments can be diversified across multiple asset classes to participate in the upside potential of the best-performing assets while moderating risk.

2. Gold Funds

Gold FOFs invest in gold mining stocks and gold securities mutual funds. These funds balance traditional securities as gold prices tend to rise when other asset classes decline. Investing in just gold stocks can be risky, but gold FOFs reduce risk through diversification.

3. International Funds of Funds

FOFs invest in mutual funds focused overseas, tapping into emerging economies' growth and diversifying exposure from domestic cycles. They offer low-cost international investment experience and reduce currency risk.

4. Multi-Manager Fund of Funds

A multi-manager fund of funds is the most common type of FOF. It comprises various mutual funds, each with a professional fund manager focused on a specific sector, theme, or strategy. By investing in a multi-manager FOF, you can gain expertise across different asset classes and investment styles at a lower cost.

5. ETF Funds of Funds

These funds invest in Exchange Traded Funds (ETFs) that cover different asset classes. ETFs trade like stocks, allowing purchase/sale during market hours. Investing in diverse ETFs allows tapping into varied themes. ETF Fund of Funds (FOF) simplifies participation compared to directly investing in ETFs, which requires a demat account. However, ETF FOFs carry a higher risk than traditional mutual fund FOFs since ETFs carry market risk.

Who Should Invest in Fund of Funds?

Funds of Funds (FOFs) offer a range of benefits for investors of all levels. They provide diversification and exposure to various assets while managing risk through reduced volatility. FOFs offer easy access to professional specialists managing each segment of the allocation.

Additionally, FOFs provide retail investors with limited access to exclusive funds or asset classes like hedge funds and real estate. Passive investors can invest in FOFs as FOF managers handle monitoring holdings. FOFs also provide a single window for varied asset class exposure and ready-made diversification.

Advantages of Investing in Fund Funds

1. Invest in a single fund to gain instant diversification across geographies, fund managers, and securities, reducing risk.

2. Investing in a fund of funds is cost-efficient and allows for investment in exclusive funds through pooled capital.

3. Simplify investing through a single window and consolidated reporting instead of multiple investments and tracking varied funds.

4. Professionally optimised asset allocation catering to an investor's risk appetite is easily available.

Possibility of crediting higher returns by participating in exclusive funds with high entry barriers.

Limitations of Fund of Funds

1. Double charging occurs when both the FOF and the underlying funds charge fees, leading to higher costs.

2. Actively managed funds of funds (FOFs) aim to allocate funds tactically, with more efficient decision-making potentially boosting returns.

3. Taxation friction arises when the fund manager churns the portfolio, leading to capital gains being passed on to investors.

3. Actively managed funds can witness style drift when fund managers deviate from the stated strategy.

4. Investing across funds diversifies risk but limits excess returns.

Conclusion

Investing in a fund of funds offers a balanced, diversified, and cost-effective approach compared to constructing your portfolio, despite the limitations of double charging and taxation. Simplified investing, liquidity, and transparency make a fund of funds suitable for both beginners and experienced investors. The outcome depends on aligning the fund's composition and strategy with your needs and risk appetite. By carefully selecting a competent outsourced fund management, you can enjoy the benefits.

Team Sharekhan
by Team Sharekhan

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