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Fund of Funds(FoF) – How do they work?

  • Akshatha Sajumon
  • Jan 12 2022
  • 8 minutes
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Gone are the days when investing in shares was considered as the only form of investment in stock markets. Today there are multiple investment products that can be used by the investors depending on their risk appetite, returns expectations, investment budget, etc. One of the many investment products available to investors includes fund of funds. This is a unique investment product with many advantages for the average investors.

Given below are the details related to the investment in a fund of funds which can help the investors make a sound investment decision.

Fund of funds

Fund of funds can be considered as the mother investment fund. This is a mutual fund scheme that invests in other mutual funds instead of individual stocks or securities. The fund manager in this case has a portfolio of other mutual funds. The fund can be designed or tailored as per the objective of the fund This fund can be formed out of investment in schemes of the same fund house or a different fund house within the country or outside. Investors can get huge diversification out of such funds as an investment in different mutual funds will provide exposure to not only different stocks but also other instruments like debt or other securities as well as different markets, sectors, and industries.

Target investors

Investment in a fund of funds provides the investor with access to multiple funds under a single roof. This gives them the opportunity to maximize their returns at relatively lower risk and lower investment budgets. Investors having a low-risk appetite can find such funds to be ideal to include in their portfolio so they can get good returns at minimal risk.

Types of Fund of Funds

There are many types of fund of funds that investors can choose from to invest in this segment. The details of the same are provided below.

  • Asset allocation funds

These funds have a diverse pool of assets like equity, debt, gold, etc. This spread of assets provides the investors with huge diversity which will eventually lead to relatively stable returns at lower risk and cost.

  • International fund of funds

International Fund of funds invests in mutual funds from foreign countries. This ensures that investors get access to the best funds from even the international market.

  • ETF fund of funds

ETF fund of funds as the name suggests is a mutual fund that invests in various ETFs. This makes investing in ETFs more accessible to investors as they do not need to open a Demat account for such investment. However, being directly associated or dependent on stocks for their returns, the risk factor in the case of ETF fund of funds is relatively higher.

  • Gold Funds

Gold funds are a portfolio of investments in gold securities or gold trading companies as per the guidelines of the asset management companies managing these gold funds. It provides the benefit of investment in gold at the same time avoiding the risks associated with an investment in physical gold.

  • Multi-manager Fund of Funds

This is the most common type of fund of funds in the market. The portfolio consists of different mutual funds that are professionally managed and have further diverse assets or industry concentration. The fund is managed by multiple portfolio managers that are responsible for their specific asset class and fund performance.

Advantages of Funds of Fund

Fund of funds have provided easy access to investors to maximize their returns not only at national but international levels. There are many advantages of these funds which are discussed below.

  • The expertise of fund managers

The fund is managed by professional fund managers that have expertise in understanding various asset classes and can manage such assets to maximize the returns of the investors. 

  • Limited capital investment

Fund of funds provides the investors with access to the top mutual funds nationally and internationally. This access is available at a relatively lower investment cost. Hence, investors with lower investment budgets can also avail of this instrument to maximize their returns by making small monthly investments as well. 

  • Diversification 

Diversification is the inherent benefit of investing in mutual funds. Funds of funds invest in multiple mutual funds so the benefit of diversification is further enhanced. The returns can be maximized at a lower risk factor.

  • Low risk of investment  

A diversified portfolio ensures that the risk of investment is significantly reduced for the investors. This fund is therefore one of the best investment opportunities for investors with low-risk appetite. 

  • Potential for higher returns

The expertise of professional fund managers along with the inherent features of diversification and low risk provide the investors with the potential to earn higher returns on their investment. The lower cost of investment further attributes to an increase in potential returns.

Disadvantages of Fund of Funds

Although there are multiple advantages of investment in a fund of funds, these investments also have certain limitations. Some of such limitations are discussed below.

  • Increased expense ratio

These are actively managed funds, hence the expense ratio of investment in a fund of funds is higher than other investment products (for example, ETFs). This can potentially reduce the returns of the investors. 

  • Taxation

The tax liability is a crucial factor to be considered while making any investment. The tax structure of fund of funds is quite complex and may potentially increase the tax liability of the investors. Hence it is necessary to know all the necessary details of such funds primarily their composition.

Tax in the form of capital gains is levied on the investors at the time of redemption of the principal amount invested in the fund. The structure of these funds is the basis for the tax levied at such time and is in line with regular mutual funds. 

  • If the fund is equity oriented (more than 65% investment in equity funds), the short term capital gains are subject to tax at the rate of 15% excluding cess and surcharge while long term gains are exempt up to Rs.1,00,000. Above Rs.1,00,000, the tax is levied at the rate of 10% excluding cess and surcharge. 
  • In case of debt oriented funds (more than 65% investment in debt funds), the short term capital gains are charged at applicable slab rates of the investor while long term capital gains are subject to tax at 20% excluding cess and surcharge. 
  • Tax on hybrid funds is levied based on their majority composition depending whether it is equity oriented hybrid fund or debt oriented hybrid fund.

Apart from this, tax is also levied on dividends received from the fund in the hands of the investor. Dividends are included in the taxable income of the investors and taxed as per the applicable slab rates.

  • Limited redemption facility

These funds are subject to a limited redemption facility. The investors may not have the opportunity to redeem their investment in liquid cash as and when needed. 

Conclusion 

Investment in a fund of funds provides the investors with potentially unlimited access to various securities and assets. This type of investment is best suited to risk-averse investors or novice investors who are looking to find a foothold in the stock markets but want to avoid the high risks associated with it.


Frequently Asked Questions

Is a Demat account mandatory for investment in a fund of funds?
No. The investment in fund of funds is held in the form of units like regular mutual funds. This means that a demat account is not mandatory for such investment products like it is in case of ETFs.

Are funds of funds good for beginners?
Yes. Fund of funds are an excellent investment choice for beginners that seek good investment products at lower risk. But it is important to understand the way they work, taxation, and other features of Fund of funds before investing in them.

What are currently the top fund of funds in India?
A, Currently some of the top fund of funds are mentioned below

  • Aditya Birla Sun Life Financial Planning FOF Aggressive Plan
  • ICICI Prudential Asset Allocator Fund (FOF)
  • Aditya Birla Sun Life Asset Allocator FoF
  • ICICI Prudential Passive Strategy Fund (FOF)

Are dividends received from fund of funds taxed in the hands of investors?
Yes. Dividends received from fund of funds were not taxed in the hands of investors but are taxed in the hands of the fund houses till FY 2019-20. However, now they are taxed in the hands of the investors according to their applicable slab rates.

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