Everything You Need Know About Fund Of Funds

The FOFs is best suited for small investors who are not willing to take higher risk or investors with lower financial resources but who are willing to have a diversified portfolio

In India, the mutual fund industry has been steadily growing year on year. As per the Association of Mutual Funds of India (AMFI), the asset under management (AUM) of all mutual fund schemes has risen by 51.24 per cent i.e. from Rs 22.26 lakh crore in March 2020 to Rs 33.66 lakh crore as of June 2021. Mutual funds offer various types of schemes to their investors such as equity-ori-ented schemes, debt-oriented schemes, index funds, etc. What if an investor wants to invest in a single fund and yet wants exposure to all the schemes? The answer to the question is ‘Fund of Funds’ (FOFs). Fund of Funds is a pooled investment fund that invests in other types of funds.

In other words, FOFs invests in other mutual funds rather than investing directly in stocks, bonds or other securities. This way the Fund of Funds invests in a variety of asset classes by investing in mutual funds offering various types of schemes. In India, FOFs has been growing rapidly since 2020. As per AMFI data, there has been an increase in AUM by almost six times since June 2015 as of June 2021 i.e., from Rs 5,781 crore to Rs 34,500 crore. In India, as of June 2021 there are 57 FOFs schemes (domestic) available. The following graph depicts the trend of AUM of FOFs (domestic). 

Defining Fund of Funds

Fund of Funds scheme is a scheme wherein the assets are invested in the existing schemes of the mutual funds. This type of investment scheme is also referred to as multi-manager investment. These schemes offer investors the opportunity to diversify their portfolio by spreading risk across various asset classes. These schemes are better suited for small investors or investors who have small capital but are willing to diversify their portfolio against distinct asset classes. This enables them to earn maximum returns at minimal risk.

These funds can be used to invest in both domestic as well as international funds as per the discretion of the fund manager and it increases the diversification. The underlying fund for FOFs is either from the same fund house which is also known as fettered or other fund houses which is also known as unfettered. Returns of FOFs are impacted by the expense ratio charged which is typically higher than an individual mutual fund. Higher fees come from the compounding of fees on top of fees.

Who Should Invest in Fund of Funds?

The FOFs is best suited for small investors who are not willing to take higher risk or investors with lower financial resources but who are willing to have a diversified portfolio. It is ideal for investors having an investment horizon of at least five years. Investing in FOFs gives an investor professional wealth management services and expertise. FOFs provide diversifica-tion across all asset classes through a single fund unlike a normal mutual fund. Experts believe FOFs is commonly better suited for smaller investors who want to gain access to a variety of asset classes or for those who don’t have expertise in selecting a single mutual fund.

FOF Fees and Charges

Fund of Funds charges fees i.e. expense ratio like any other mutual fund schemes. But unlike mutual funds, FOFs charges extra cost over and above general management, administrative and fund manager’s fees. A FOFs investor pays double charges because the underlying funds in the FOFs also have their annual costs and fees. For instance, FOFs might charge 1 per cent of the expense ratio for investing in mutual fund schemes and that underlying mutual fund charges another 1 per cent management fee. So, summing it up, FOF investor pays 2 per cent i.e. double. After all the charges and taxes are taken care of, the returns are generally lower than a single mutual fund.

Advantages and Disadvantages

There are certain distinct advantages and disadvantages of FOFs:

Advantages

•Diversification: Fund of Funds invests in distinct mutual funds in the market which have specializations in each sector or asset of fund. This delivers optimum returns to the investors with lower risk as they invest in variety.
• Ease in Tracking: As FOFs invest in other mutual funds, tracking the NAV is easy as its just one portfolio consisting of a variety of mutual funds. Whereas, tracking NAV, reviewing and managing becomes a little difficult in case of multiple individual mutual funds as compared to FOF.
•Professional Management Expertise: FOFs require highly trained people with relevant experience of handling and managing the portfolio. FOFs offer professional management services, where it provides investors with a fund which is backed by proper research.
• Opportunity for Small Investors: FOFs allows investors with less financial resources to diversify their portfolio by investing in a single fund. It is ideal for small investors who are not willing to take risk as this fund is professionally managed by experts.

Disadvantages

• High Expense Ratio: FOFs have higher expense ratio as compared to single mutual fund. In addition to normal administrative, management fee there are additional charges related to underlying funds.
•​ Excess Diversification: FOF invests in multiple mutual funds which invest further in stocks and bonds or any other security. This gives rise to the possibility of the FOF ending up investing in same stocks and securities through different funds. Therefore, frequent vigilance is required to hold the balance. Otherwise, it will end the potential of diversification.

Taxation
Under the current income tax regime FOFs is treated as a non-equity fund and taxed accordingly. So, even if the FOFs is investing in equity-oriented funds, it won’t enjoy the benefits of equity-oriented taxation, as the FOF itself is regarded as non-equity. If capital gain arises within 36 months, then it will be regarded as short-term capital gain which will be taxed as per the Income Tax slab rates and if capital gain arises after 36 months then it will be regarded as long-term capital gain which will be taxed at the rate of 20 per cent. Subsequently, in case of FOF there is double taxation on dividend. For FOFs investing in equity-oriented mutual funds, there is a dual levy of dividend distribution of tax (DDT) i.e. when the domestic companies distribute dividends to their shareholders and again when the FOF distributes to its unit-holders.

The following table depicts the top three asset allocator FOFs available on the basis of three-year return along with their AUM.