What is FOF (Fund of Fund): Meaning, Type and How to Choose

Fund of Fund (FoF) is a pooled fund investment strategy that invests in a portfolio of other investment funds rather than investing directly in individual securities. FoF uses its capital pool to invest in mutual funds or other hedge funds. This type of investing is often referred to as multi-manager investment. 

Funds of Funds aim to achieve broader investment diversification at minimal risk, managed by different managers or investment strategies through a single investment. Funds of funds tend to have higher expense ratios than regular mutual funds because the fund has to meet its expenses from a restricted or smaller asset base. This investment can be made in both domestic and international funds, as per the preferences of the asset management company. This activity increases the heterogeneity, which means rising diversification in the portfolio through the fund of funds.

Degree of Risk in Fund of Fund

FoF investment strategy has portfolios with varying degrees of risk, which is decided by the aim of the investment manager. These risk profiles depend on the fund’s investing objective. If the primary objective of the portfolio manager is to maximise returns or earnings, then funds with higher NAV will be targeted despite being aware that they possess high risk. However, if the investment aims to earn stability, the manager will invest in low-risk instruments using the pooled financial resources. Therefore, high-risk investments are made to yield greater earnings, and low-risk funds are purchased to have a stable portfolio.

The FOF may be fettered, meaning it only invests in portfolios managed by one investment company. Alternatively, the FOF can be unfettered, letting it invest in external funds controlled by other managers from other companies. 

Types of Fund of Funds

• Asset Allocation Fund- These are balanced mutual funds wherein investors put their money into a diverse asset pool – with securities comprising equity, debt instruments, precious metals, etc. Seasoned investors use this investment strategy to redistribute their risk burden and enhance their scope of earnings guaranteed by the relatively stable securities present in the portfolio. This is also known as the Multi-Asset Fund of Funds.
   
• Gold Funds- Gold is a precious metal, and its value is bound to increase with time. Gold funds are mutual funds that directly or indirectly invest in gold reserves. Money is invested in stocks dealing with gold production and distribution, physical gold, and mining company stocks. The primary purpose is to create wealth for investment purposes and provide the investor with a cushion against market collapse. Investing in gold funds is a convenient way to invest in an asset without purchasing the commodity in its physical form. Gold funds are open-ended investments, meaning you can buy/sell units of open-ended fund schemes anytime. Open-ended funds have no maturity period, meaning you can remain invested in the scheme for as long as you want.
• International Fund of Funds: Mutual Funds operating in foreign countries are targeted by the International Fund of Funds. This allows investors exposure to international stocks, bonds and assets. They are used to yield higher returns through the best-performing stocks and bonds of the respective country. International FoF creates global diversification in the portfolio and explores opportunities beyond the domestic market
   
• Hedge Fund of Funds: These FoFs invest in a portfolio of hedge funds, which improve investment performance and insulate returns from market risk. Hedging is a strategy that tries to limit risks in financial assets. It uses financial instruments or market strategies to offset the risk of any adverse price movements. Hedge fund of funds provides investors with exposure to a diversified range of hedge fund strategies to secure their investment, such as long-short equity, global macro, event-driven, and others. Some Hedge Fund of Funds are The Blackstone Group, Blackrock Alternative Investors, and Credit Suisse Alternative Fund Solutions.
   
• Private Equity Fund of Funds: These FoFs invest in a portfolio of private equity funds, which invest in private companies. Investors can buy stock and invest in private companies. Private equity funds allow investors to participate in the potential growth and returns of private equity investments.
   
• Real Estate Fund of Funds: Real Estate FoFs invest in real estate funds. These investments are focused on various types of real estate assets, such as commercial real estate, residential properties, development projects, or other real estate-related investments. It enables investors to access the real estate market by investing in this type of fund of funds.
   
• ETF Fund of Funds: This FoF invests in Exchange-traded funds as they are more accessible than a direct investment in this instrument. This is because investing in ETF requires a Demat account while investing in ETF fund of funds has no such limitations. This type of FoFinvest in a portfolio of other ETFs rather than individual stocks or bonds. These funds allow investors easy access to a broad range of asset classes and investment strategies.

Each type of fund of funds has different objectives, strategies and assets at the discretion of its asset management company. Investors should pick the type of FoF that meets their investment goal while bearing a minimal risk

Should You Invest in Fund of Funds and What are its Advantages?

The primary benefit of Fund of Funds, or why people often opt for them, is that highly trained professionals manage these funds. This ensures that investment decisions are made soundly, and they can make accurate market predictions to a certain extent, ultimately leading to low risk and high return.
 

The main reason to invest in FoF is maximum return while taking minimal risk. Small investors (investors with a small pool of funds) who wish to diversify their portfolio can opt for such Mutual Funds, which, with the gift of compounding, yield a decent return in the long run. Since the portfolio of these mutual funds is broad and diversified, the investor can also access high-value funds.

Taxation on Fund of Funds
 

If FoF is classified as an equity fund, the tax on Short Term Capital Gains(STCG) is 15% on investments sold within one year of investment, and the tax on Long Term Capital Gains (LTCG) is 10% for profits exceeding Rs 1,00,000 and sold after one year of investment. Under India's current Income Tax regime, a FOF is treated as a non-equity fund and consequently taxed accordingly. In other words, even though a FOF may be investing in equity-oriented funds, the FOF itself is not regarded as an equity-oriented fund. if units are redeemed within three years of purchase, the short-term capital gains tax is applied. The gains are added to the individual’s income and taxed according to the individual's tax slab. If it is sold after three years, an LTCG tax of 20% with indexation is applicable.

Consequently, the tax benefits currently available to an equity fund are not available to a FOF. But the good thing is that the dividend received on the investment is not taxable, as the issuing fund house bears the burden.

Summary:

Fund of funds can appeal to investors seeking diversification across different managers or strategies without having to select and monitor individual investments themselves. However, they can also have higher fees than investing directly in securities or funds. Fund of Funds are generally better suited for smaller investors who want access to a range of asset classes while opting for minimal risk. Fund of Funds operate better in the long run, and thus, you might have to lock your investment for a considerable period. Ensure your liquidity needs are fulfilled through other sources before the option for Fund of Fund