Mutual Funds: Should retail investors look at Fund of Funds?

According to the investment ideology, FOFs are structured as mutual funds, hedge funds, investment trusts, private equity funds, ETFs, etc. Some of the popular FoFs are discussed below.

By P Saravanan & Abhishek Totawar

MOST INVESTORS KNOW about mutual funds and usually invest in either equity or debt instrument-based funds. But only a few investors are aware that there exist funds which invest in other mutual funds (MFs) or exchange traded funds (ETFs). Such types of funds are known as Fund of Funds (FoF). Let us try to understand what are the salient features of FoF, associated risks and what kind of investors should invest in such funds.

Features of FoFs
They are a type of mutual fund which utilise their pool of resources by investing in various kinds of mutual funds in the market. Investing in FOFs provides a significantly higher degree of diversification as these invest in multiple schemes with various asset classes. So, generally FOFs are protected against both high volatility and short-term fluctuations. Investment amount in FOF could be similar to that of a typical MF investment. Investors can also opt for a systematic investment plan (SIP) scheme. Thus, they have all the benefits such as compounding effect, averaging out, etc. As FoF invests across the different schemes, thorough due diligence is carried out by professional fund managers.

Type of FoFs
According to the investment ideology, FOFs are structured as mutual funds, hedge funds, investment trusts, private equity funds, ETFs, etc. Some of the popular FoFs are discussed below.
Asset allocation funds: These F0Fs invest across various asset classes ranging from equity, debt to other assets such as gold, metals and commodities.

Foreign or International FoFs: These FoFs invest in mutual fund schemes or bonds or even shares of global companies.

Gold FoFs: As the name suggests, these funds invest in gold funds. They also invest in physical gold or invest in stocks of gold mining companies.

ETF FoFs: Exchange Traded Funds invest in a variety of asset classes such as equity, commodities, etc. ETF FoFs invest their money in such ETFs.

Risk while investing in FoFs
FoFs invest in funds and schemes which have their own expense ratio. On top of that, expense ratio of the FOFs is added. So generally the expense ratio of FoFs is higher than standalone debt or equity mutual fund schemes. 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. As FoFs invest in multiple equity funds, there is a higher probability of overlapping of asset classes and or instruments.

FoFs are for which investors
Those investors who wish to invest in multiple mutual fund schemes can consider investing in FOFs as they provide access to investments across various schemes. Risk-averse investors can also invest in such funds. However, as like any other type of investments, FoFs also generate good returns only if your holding period is more than three years. For an Indian small investor, an international FoF will give access to global investment opportunities which is not available in India at present (e.g., investing in the stocks of Apple, Microsoft, Amazon, Google, Tesla, etc.).

To conclude, FoFs are similar to mutual funds which are subject to market risk and investors need to assign an appropriate weight in their overall portfolio.

The writers are faculty members in IIM Tiruchirappalli

BETTING ON FoFs
FoFs are protected against both high volatility and short-term fluctuations due to higher degree of diversification
Expense ratio of FoFs is higher than standalone debt or equity mutual fund schemes
As FoFs invest in multiple equity funds, there is a higher probability of overlapping of asset classes or instruments
FOFs are structured as mutual funds, hedge funds, investment trusts, private equity funds, ETFs, etc