Mutual funds generally invest your money in equity or debt instruments based on the type of fund you select. But do you know that there are also funds that invest in other mutual funds? Popularly known as FOFs (Fund of Funds), they are most popular amongst risk-averse, long-term investors. Check out what they are and how they work.
When you invest in a mutual fund, let’s say an equity mutual fund, your money is spread across stocks and other equity-related instruments. Similarly, when you invest in a debt fund, your funds are spread across multiple debt instruments. But there are also mutual funds that invest in other mutual fund schemes.
Known as Fund of Funds (FOFs), these funds aim to achieve a broader diversification and asset allocation by investing in funds spread across categories. Let us try to understand these funds in detail.
Unlike a standard mutual fund scheme, like equity or debt, where investments are spread across related instruments, a FOF holds other mutual funds in its portfolio. It is also possible that a FOF might hold other schemes of the same fund house. Moreover, some of the FOFs also invest in international funds.
FOFs can be of different types depending on the investment ideology behind the scheme. For instance, they can be structured like mutual funds, hedge funds, ETFs, investment trusts, or even private equity funds.
Some of the most popular types of FOFs in India are:
As the name suggests, these FOFs invest in various asset classes. They can be equity, debt, or even commodities such as metals, gold, etc.
International or overseas FOFs invest your money in mutual fund schemes or bonds offered by foreign companies.
Gold FOFs generally invest in gold funds. But they can also invest in physical gold or even stocks of companies involved in gold mining.
ETFs or Exchange Traded Funds invest in various instruments such as equity, stocks, and commodities. ETF FOFs invest in such ETFs.
Now that you know Fund of Funds meaning and types, here are the top features:
Mutual funds offer a lot of diversification by investing in multiple instruments of the same or different asset classes. By investing in mutual funds, FOFs take diversification to an entirely different level.
FOFs are generally known to be moderately risky. As the money is invested in multiple funds and schemes, FOFs are protected against high volatility and short-term fluctuations. If a particular fund or asset class is underperforming, other funds/schemes or asset classes add stability to the portfolio.
FOFs are considered as debt funds even if a FOF only invests in equity funds. For investments held over 36 months, LTCG (Long-Term Capital Gains) at the rate of 20% with indexation benefit is applicable. The returns from investments held for less than 36 months are added to the taxable income of the investor and are taxed accordingly.
The funds and schemes that FOFs invest in have their own expense ratios. Combine it with the expense ratio of the FOF, and you are looking at an expense ratio that is higher than standard expense ratios of equity and debt schemes.
While diversification is good, over-diversification can harm your investment portfolio. This is mostly because over-diversified investments are not able to make the best use of a particular asset or instrument when they are outperforming. So, if you plan to invest in FOFs, manage your portfolio exposure accordingly.
If a FOF you select, invests in multiple equity funds, there is a high chance of over-lapping of asset classes or instruments. For instance, two equity funds might have significant exposure to the banking sector. If the banking sector starts underperforming, this could significantly affect your investment.
Investors who want to invest in multiple mutual fund schemes can consider investing in a FOF. A single FOF investment could provide access to investments across various schemes. Also, as these funds are highly diversified, their risk level is generally moderate. So, even risk-averse investors can invest in these funds.
But note that FOFs, too, are generally ideal for long-term investments. So, prefer them if you have an investment horizon of above three years.
Before investing, try to know more about what Fund of Funds in detail is, their advantages, risks, types, and more to ensure that they meet your investment profile and financial objectives. Rather than focusing on generating quick profits, try to become a savvy investor as this will prove more beneficial in the longer run.