Fund of Funds: An effective diversification tool

June 30, 2021 5:37 PM

If you are an investor with limited know-how of various asset classes and their functioning, investing in a FOF that meets your investment requirement can be a practical starting point.

Mutual Fund, MF, MF inflow, Systematic Investment Plan, SIP, SIP inflow, net MF inflow, equity funds, tax, income tax, Short term capital gains, Long term capital gains, bonds, tax on earnings, investment in bonds, mutual funds, debentures, cash market, derivatives, currency, commodity markets, Share Market Today, Share Market update, Mutual fund, Fixed income funds, heavy outflows, January 2021, debt mutual funds, Liquid funds, Low Duration Fund, Money Market Fund, Medium to Long Duration Fund, Long Duration Fund, Gilt FundAnother variant in this category is a FOF which provides exposure to different types of ETFs within a single portfolio.

For an investor looking to take exposure to equities, there are a variety of investment vehicles to choose from. One such investment option is the Fund of Funds (FOF). A FOF is a mutual fund that primarily invests in the units of another Mutual Fund scheme. Essentially, it is an investment strategy of holding a portfolio of other investment funds rather than investing directly in stocks, bonds, or other securities. The underlying investments could be the units of mutual fund schemes either from the same fund house or other fund houses.

Types of FOFs:
There are a wide variety of FOF options available. The underlying can be only equities or it could be a combination of various asset classes.

1) Asset Allocation FOF
As the name suggests, for asset allocation such a FOF will have funds investing in equity, debt, and gold as its underlying assets. For example, ICICI Prudential Asset Allocator Fund. If you are an investor looking for a one-stop solution for your asset allocation needs, you may consider a FOF which deals with asset allocation.

2) International FOF
The other widely popular category of FOF has international investing as its underlying theme. The fund manager here invests in Indian mutual fund schemes which invest across various global markets or will invest in mutual funds operating in target markets. For example, ICICI Prudential Global Advantage Fund. Here, the fund comprises funds that are India-based and invest across both developed and emerging markets.

3) Gold-based FOF
A Gold FOF will invest in mutual funds which invest in the yellow metal such as the Gold ETF. For example, ICICI Prudential Regular Gold Savings Fund (FOF) invests in the ICICI Prudential Gold ETF.

4) ETF FOF
Such a FOF will have ETFs as its underlying. Over the last couple of years, the ETF space has exploded with a variety of thematic/sectoral and smart beta ETFs. The FOF structure is created such that investors even without a Demat account can access the ETF. (Demat account is mandatory for investing in ETFs). For example, ICICI Prudential Nifty Low Vol 30 ETF Fund of Funds (FOF). This FOF invests in ICICI Prudential Nifty Low Vol 30 ETF that replicates the Nifty 100 Low Volatility 30 Index in the same proportions. The low vol index is comprised of the steady least volatile stocks in the market and endeavours to provide higher risk-adjusted returns. In this case, the FOF portfolio consisted of a single ETF.

Another variant in this category is a FOF which provides exposure to different types of ETFs within a single portfolio. One such fund is the ICICI Prudential Passive Strategy Fund (FOF) which actively manages the market cap, sector/thematic, and factor-based allocation through ETFs. As of May 2021, the portfolio consists of ETFs based on indices such as S&P BSE 500, Nifty, IT, and BHARAT 22.

5) Debt-based FOF
If you are an investor looking to allocate towards debt but are unsure which category of fixed income mutual fund is suitable for you, then this FOF can come in handy. Here, the fund manager depending on the evolving macros will allocate corpus across categories of funds that are likely to make the most from the prevailing market situation.

6) Equity-based FOF
Similar to debt-based FOF, an equity FOF will have exposure to a variety of equity mutual funds with varying investment styles within a single FOF. For example, The portfolio of ICICI Prudential India Equity FOF consists of eight funds from five different fund houses. Each of these funds is unique in terms of the management style and covers a wide spectrum of stocks across market capitalisation.

Advantages of FOF

1) Access despite limited capital
Through FOFs, investors even with limited capital get access to invest across asset classes such as equities, debt, liquid funds, gold, commodities, and especially international indices. Otherwise, accessing each of these asset classes individually could prove to be cost-intensive for a lay investor. Similarly, if an individual wish to invest in some international market, the cost associated would be almost prohibitive in nature when one considers the currency fluctuation aspect as well. Now with FOF, an investor need not worry about such challenges.

2) Diversification
Through a single FOF, an investor gets the opportunity to diversify within one unique asset class or multiple asset classes based on the FOF chosen.

3) Benefit of professional expertise
When investing in a FOF, an investor gets the benefit of the portfolio being managed by a professional fund manager. This assumes significance especially during times of rebalancing. As a lay investor, one may not be able to catch the change in market trend or respond quickly depending on the change in market conditions, a deficiency that gets addressed through a professional fund manager.

As FOFs take exposure to multiple funds, the overall cost/expense ratio tends to be generally higher than individual mutual funds but the costs have regulatory upper limits and hence it doesn’t pose a roadblock. In the case of ETF FOF, the expenses associated tend to be relatively lesser as the underlying cost of ETF tends to be cheaper. These ETFs provide excellent flexibility to the investors in terms of the well-diversified portfolio that too at a lesser cost.

When it comes to taxation, FOF is treated as a non-equity fund. This means the short term is defined as up to three years (36 months) and the long term is three years plus. If the units are sold after 36 months, a long-term capital gain tax of 20% with indexation is charged. However, it may be noted that the FOFs with a minimum of 95% in equity ETFs are taxed as per Equity taxation.

To conclude, if you are an investor with limited know-how of various asset classes and their functioning, investing in a FOF that meets your investment requirement can be a practical starting point. This is because it allows an investor to invest in a diversified portfolio and over the long term help generate better risk-adjusted returns.

by, Chintan Haria, Head- Product Development & Strategy, ICICI Prudential AMC

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