Mutual funds have become a favourite among many Indian investors due to their potential for better returns and lower risk. However, a specific category of mutual funds, known as Fund of Funds (FOFs), has also caught the attention of investors. While both options aim to grow your money, they work quite differently. So, what exactly sets Fund of Funds apart from regular mutual funds? Should you consider investing in them, or is a standard mutual fund a better option?
Let’s break down the key differences and help you understand which investment might suit you best.
What Exactly is a Fund of Funds (FOF)?
A Fund of Funds (FOF) is a type of mutual fund that invests your money in multiple mutual funds rather than in individual stocks, bonds, or other financial instruments. This allows you to benefit from greater diversification without needing to manually pick different funds. Essentially, FOFs act as a ‘multi-manager investment,’ where both the FOF manager and the managers of the mutual funds it invests in contribute to managing your investment.
One of the major selling points of FOFs is the ability to diversify investments across different mutual funds, sectors, and asset classes, reducing overall risk compared to investing in just one mutual fund.
Key Differences Between Fund of Funds and Regular Mutual Funds
1. Investment Structure
The primary distinction lies in how your money is invested.
- In regular mutual funds, your money goes directly into a portfolio of stocks, bonds, or other financial assets.
- In FOFs, your money is invested in various mutual funds, and these funds may themselves invest in a mix of assets, offering an additional layer of diversification.
2. Risk and Diversification
- Regular mutual funds can sometimes focus on specific sectors, themes, or asset classes, which may lead to less diversification.
- On the other hand, FOFs spread investments across multiple mutual funds, often spanning different sectors and asset classes, lowering the overall risk by ensuring greater diversification.
3. Fund Management
- Regular mutual funds are managed by one or two fund managers who make decisions about where and how to invest.
- FOFs involve not only the FOF manager but also the managers of the mutual funds in which the FOF has invested. This means multiple fund managers’ expertise comes into play, which can be advantageous but also adds complexity.
Advantages of Investing in Fund of Funds
1. Access to Multiple Asset Classes
FOFs offer the benefit of diversification without needing to allocate large sums of capital to multiple funds. With even a small amount of money, you can gain exposure to a variety of assets and mutual funds.
2. Simpler Investment Management
Since all your investments are consolidated under a single FOF, you don’t need to manage multiple folio numbers or worry about rebalancing different mutual funds. FOFs make the process easier by offering an all-in-one investment solution.
3. No Tax on Rebalancing
One big advantage of FOFs is that you do not incur capital gains tax during internal fund rebalancing, unlike when you manage multiple mutual funds yourself. This is considered an internal transaction.
4. Ideal for New Investors
If you’re new to investing or unsure how to diversify your portfolio, FOFs can simplify the process. Since the fund manager takes care of selecting a diversified mix of mutual funds, you won’t have to worry about picking the right mutual fund yourself.
Drawbacks of Fund of Funds
1. Higher Expense Ratio
FOFs tend to have a higher expense ratio compared to regular mutual funds. Why? Because not only do you pay management fees for the FOF, but you also bear the costs of the underlying mutual funds in which the FOF invests. This double-layer of fees can eat into your returns over time.
2. Tax Treatment
FOFs may not be as tax-efficient as regular mutual funds. If an FOF’s investment in domestic equity funds is less than 90%, it is treated as a debt fund for tax purposes. This could result in higher tax liability for investors, especially when compared to equity-focused mutual funds.
3. Duplication of Portfolio
Sometimes, an FOF might invest in multiple mutual funds that have overlapping assets or similar portfolios. This reduces the effectiveness of diversification and may not give you the desired spread of risk.
Who Should Invest in Fund of Funds?
If you’re a beginner and don’t feel confident in selecting mutual funds yourself, FOFs can be a good starting point. They offer diversification, lower risk, and simplified investment management. However, make sure to keep an eye on the expense ratio and understand the tax implications before diving in.
On the other hand, if you’re an experienced investor willing to take on more risk for potentially higher returns, or if you want to minimize costs, investing directly in regular mutual funds might be a better option. With regular mutual funds, you have more control over your investment choices and can avoid the added layers of fees and management involved in FOFs.
Ultimately, whether FOFs or regular mutual funds are right for you depends on your risk tolerance, financial goals, and understanding of the market. Always assess these factors carefully before making an investment decision.
