What are Mutual Funds - Fund of Funds (FOFs)

Mutual funds that invest in other mutual funds? Sounds confusing? That's Fund of Funds for you. Read on...

What is Fund of Funds
Acronymed as FOFs, Fund of Funds is a type of mutual fund which invests in various other mutual funds in the market. These are also known as multi-manager investments since there would typically be managers for each fund that a particular FOF is invested in.

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

Why do we need FOFs
At first, the idea of Fund of Funds sounds quite strange, and mostly it is. But in some cases, investing in FOFs can provide us with a significantly higher degree of diversification as these invest in multiple schemes with various asset classes. Thus, for example, instead of investing in 4 different funds of Large Cap, Mid Cap, Small Cap, and Debt, you may just be able to get hold of a suitable Fund of Funds that does this entire management for you.

Is the investing style any different than investing in Mutual Funds?
The investment amount in FOF could be similar to that of a typical mutual fund investment. Investors can also opt for a systematic investment plan (SIP) scheme, just as they have in any mutual fund. Thus, they have all the benefits such as compounding effect, averaging out, etc. Many times, the investors may not even know whether they are investing in Mutual Funds or FOFs, unless they read the name of the fund carefully.

Popular FoF types
There are various popular categorizations among Fund of Funds.

1. Asset allocation funds 
These funds consist of a diverse asset pool – with securities comprising of equity, debt instruments, precious metals, etc. This allows Asset Allocation funds to generate high returns through the best performing instrument, at a reduced risk level guaranteed by the relatively stable securities present in the portfolio. 
e.g. Aditya Birla Sun Life Financial Planning FOF invests 30% of its funds in Equity funds (Large-Cap, Mid-Cap as well as Small-Cap) and 70% in Debt-based funds and other instruments.

2. Gold funds
Investing in different Mutual Funds, primarily trading in gold securities are gold funds. Fund of funds belonging to this category can have a portfolio of Mutual Funds or the gold trading companies themselves, depending upon the concerned asset management company. 
e.g. SBI Gold Fund.

3. International funds
Mutual Funds operating in foreign countries are targeted by the international fund of funds. This allows investors to potentially yield higher returns through the best-performing stocks and bonds of the respective country. 
e.g. Motilal Oswal NASDAQ 100 FOF

Drawbacks of FOFs

FOFs come with their own demerits.

1. Expenses
FOFs invest in funds and schemes which have their own expense ratio. On top of that, the expense ratio of the FOFs is added. Higher fees come from the compounding of fees on top of fees. So generally the expense ratio of FOFs is significantly higher than standalone debt or equity mutual fund schemes. 
As an example, Nippon India Asset Allocator FoF investors have to bear the expense ratio of the FoF (0.19%) and the weighted average expense ratio of its constituents  - Nippon India Small Cap Fund (1.06%), Nippon India Growth Fund (1.26%) and Nippon India Large Cap Fund (1.18%)

2. Over diversification
Though diversification is good, over-diversification may not be a good idea, because over-diversified investments may not be able to make the best use of a particular asset when they are outperforming compared to other assets. 

3. Overlapping of asset classes
As FOFs invest in multiple equity funds, there is a higher probability of overlapping asset classes and or instruments.

4. Taxation
Taxation is another aspect that makes investing in FOFs inefficient. Read more about it in the last section of this blog.

FOFv Vs ETFs

Exchange-Traded Funds (ETFs) are definitely a better alternative to FOFs. In fact, most of the FOFs go on and invest in their own corresponding ETFs.

Example: Motilal Oswal NASDAQ 100 FOF invests all its funds in Motilal Oswal NASDAQ 100 ETF.

If that is the case, then it actually makes no sense to invest in FOFs, rather we should be investing in ETFs. Of course, if someone has no access to a trading and Demat account, then FOF is the only option to opt for.

ETFs have a lower expense ratio, are more liquid, and have a more efficient taxation structure on capital gains than FOFs.

How are FoFs taxed?

FOFs are at a clear and distinct disadvantage as far as taxation is concerned.

1. STCG Tax (Short Term Capital Gains Tax)
STCG from the commonly used equity-based mutual funds is 15% flat, while that for FoFs is as per the existing tax slab, which could be as high as 30%

2. LTCG Tax (Long Term Capital Gains Tax)
LTCG's definition of FoFs and equities is different. We get LTCG benefit in equity-based mutual funds after 1 year, while the equivalent period is 3 years for FoFs. This means that we have to wait 2 years longer in the case of FoFs to get the same benefit as we get for mutual funds.

Summary

Theoretically, FOF sounds like a great idea to diversify and protect investments. However, considering the high expense ratios, poor tax treatment, and added complexity, they may make sense only in cases where diversification may be needed, and the investor does not have access to a securities account. In most cases, actively managed mutual funds and ETFs will serve the purpose much better.

Regards

Manoj Arora
Official Website