Fund of Funds- Fund of Funds Definition and Meaning

Last Updated: 6 Aug 2024

In most of the developed markets of US, Europe and South East Asia, the concept of Fund of Funds or (FOF) is extremely popular. Most of the financial planning is done through the FOF route by advisors. However in India, Fund of Funds (FOFs) are a fairly new concept. There are a variety of FOFs in India which are predominantly international funds launched by domestic AMCs with a foreign parent. How does such an FOF work?

In a typical FOF, the domestic fund invests in the funds of the parent and gives the investor an indirect exposure to US stocks and indices or even of other countries. Similarly there are commodities FOFs that combine equities and commodities and reduces overall risk. Let us understand the working and the nuances of an FOF with a series of rhetorical questions.

How do Fund of Funds (FOFs) allow me to participate in global markets

Actually, FOFs offer the easiest and most effective option to participate in global markets. Let us assume that you are substantially exposed to Indian markets and are worried about your returns getting impacted by a sudden downturn. In this case, you can diversify risk by opting for international FOFs.

These FOFs will benefit from an upturn in global markets. For example, the Dow and the NASDAQ have been among the top performers in the last 2 years since the pandemic began. You can use the FOF route to participate in these markets. They are passive investments so timing of entry does not matter too much.

How is it that Fund of Funds (FOFs) help to diversify risk?

That is one of the most important benefits of investing in an FOF. There are FOFs available that are dedicated to commodities like gold, silver and other asset classes. This helps you to participate in the commodity up cycle and also de-risk your portfolio risk which is predominantly tilted towards equities.

Similarly, FOFs on international funds can help you diversify your country risk. More importantly there are fund of ETFs which combine a variety of ETFs like Beta Plus, gold, Metals and Reverse Index to give you an outperformer in most market conditions.

How do Fund of Funds (FOFs) help in financial planning?

As stated earlier, this is common in matured markets, especially among the institutional investors like banks, pension funds, sovereign funds etc. In more matured markets, FOFs are a very important tool of financial planning, although this is yet to catch up in India. Essentially financial planning is about achieving your goals through intelligent asset allocation. But what if you are not able to get your required and targeted appropriate mix?

The answer is FOF. That is where FOFs can come in handy. In fact, in other countries there are financial advisors at the level of individuals and institutions purely specializing in combining FOFs to give you risk-return combinations best suited to your unique requirements. In India, financial advisors still rely on mutual funds and insurance to meet most of your needs. Adding FOFs, subject to availability, can help advisors choose from a much wider array of products.

How are the fees on fund of funds (FOF); higher or lower?

There is a fear that you may end up paying twice the loan on FOFs at multiple levels. However, that is not the case. Most FOFs are specifically designed to keep your cost as low as possible. To make them competitive, FOFs charge very low fees and this makes them competitive as an asset class. It is true that FOFs in India are yet to mature to that level of sophistication.

However, it is expected that once FOFs become more rampant in India, the relevant costs will also come down proportionately to that extent. Globally, the low fee structure of FOFs is their biggest advantage and this adds to their allure for financial planners as it does not burden the investors too much in the long run. Low cost is the key to FOFs becoming critical and meaningful tools for financial planning and asset allocation.

Does the FOF act like a hedge for my equity fund positions?

That would largely depend on what your FOFs constitute. But broadly, the answer would be yes. Most of the equity funds in India are purely long-only funds. As a result, during market downturns, these equity funds tend to give negative returns like the index, without any exception and only the extent of fall may vary.

We typically get to see this trend in huge downturns like in 2001, 2008 and during the pandemic in 2020. During this period, most equity funds gave negative returns. Here, FOFs can be extremely useful as they handle multiple asset classes and by shifting your portfolio you can shift assets classes. It kind of acts as a natural hedge to your equity portfolio.

Are there any risks investing in FOFs in the India context?

That is a good question and I can straight think of some key risks in FOFs in India. Here are a few of them.

1. The first big risk in India is the availability. You just don’t have enough of FOFs and enough variety to give a choice to the investors. Hence, choice is limited.
2. , the ecosystem is not there. There are not enough institutions buying into FOFs and hence there are not too many advisors. It is like a Catch-22 situation.
3. An important shortcoming in the Indian context is the tax treatment of FOFs. Currently, FOF is treated as non-equity fund even if it is a fund of equity funds.
4. as a result, FOFs are treated as short term gains if held for less than 3 years and long term gains only if held beyond that.
5. Also, in the case of FOFs, STCG is payable at your peak tax rate and the LTCG is payable at 20% after indexation. Both are higher than the rates on equities.
6. The AMFI and other investment bodies have been trying to reason with the government to rectify this anomaly in the budget. However, despite several attempts, the budget has not been very receptive to this idea. This will be the key to wider acceptance of FOFs.