A Fund of Funds (FoF) is a unique type of mutual fund that, instead of investing directly in stocks and bonds, invests in the units of other mutual fund schemes.
It offers a way to achieve a high level of diversification with a single investment, essentially creating a managed portfolio of funds.
How Do Fund of Funds Work?
An FoF manager researches and selects a basket of other mutual funds that align with the FoF's investment objective.
For example, an "Aggressive Equity FoF" might invest in a mix of the best-performing large-cap, mid-cap, and small-cap funds from various AMCs.
There are two main types of FoFs available to Indian investors:
Domestic FoFs: These funds invest in other mutual fund schemes within India.
They might focus on a specific strategy, like building a portfolio of the best equity funds or creating a multi-asset portfolio by investing in different equity, debt, and gold funds.
International FoFs: These funds invest in mutual funds that are domiciled in other countries.
This is the most common and practical way for a retail investor in India to get exposure to global markets and invest in international companies like Apple, Google, or Amazon.
The Pros and Cons of Investing in FoFs
Advantages:
- Instant Diversification: With a single investment, you can get exposure to multiple funds, fund managers, and investment strategies.
- Access to Global Markets: International FoFs provide a simple and convenient gateway to geographical diversification, which can be difficult and expensive for a retail investor to achieve directly.
- Professional Selection: You are relying on the expertise of the FoF manager to select a good portfolio of underlying funds.
Disadvantages:
- Layered Expenses: This is the biggest drawback of FoFs.
You have to pay the expense ratio of the FoF itself, in addition to the expense ratios of all the underlying funds it invests in. This double layer of fees can significantly eat into your returns.
- Taxation: The tax treatment of FoFs can be less favorable.
Even if an FoF invests primarily in Indian equity funds, it is typically taxed like a debt fund, which can result in a higher tax liability compared to investing directly in the equity funds.
The Verdict for Beginners
While domestic FoFs can seem appealing for their simplicity, their value proposition is often weak due to the high layered costs.
A beginner can achieve similar diversification more cost-effectively by investing in a single good multi-cap or flexi-cap fund.
However, International Fund of Funds represent a compelling use case.
They solve a real problem for Indian investors by providing easy and affordable access to global equity markets.
For an investor looking to diversify their portfolio geographically and invest in the growth of global companies, an International FoF can be a valuable addition to their portfolio, despite the higher costs.