Fund of Funds (FoFs): A Gateway to Diversified Investment Portfolios
The Indian mutual fund industry has witnessed significant evolution in its investment products, with Fund of Funds (FoFs) emerging as an innovative solution for investors seeking broader diversification and professional management across multiple schemes.
FoFs are mutual fund schemes that invest in other mutual fund Schemes rather than directly in stocks, bonds, or other securities. This investment vehicle offers investors a unique opportunity to access multiple fund management styles, asset classes and investment strategies through a single investment.
SEBI says ‘A Fund of Fund is essentially a “fund made up of funds.” It pools money from investors and invests it in a collection of other mutual funds, or exchange-traded funds (ETFs). By doing so, it provides a diversified investment portfolio managed by experts.’ (https://investor.sebi.gov.in/fund_of_fund.html)
Key features of FoFs include:
- Diversification across multiple schemes
- Professional fund management at two levels. A multi-manager fund, uses multiple fund managers or investment firms to select and manage the underlying funds within the portfolio.
- Access to specialized investment strategies in certain kinds of FoFs.
- Simplified portfolio management for investors
- Lower risk through broader diversification
The FoF segment has shown remarkable growth, with Assets Under Management (AUM) rising significantly. This growth has been particularly strong in International FoFs and Exchange Traded Fund FoFs.
Investment Strategies
FoFs employ various investment strategies to meet different investor needs:
- Asset Allocation FoFs: These funds invest across equity, debt, and hybrid funds to maintain a specific asset allocation.
- International FoFs: Provide exposure to global markets by investing in international funds.
- ETF FoFs: Invest in Exchange Traded Funds, offering lower costs and enhanced liquidity.
- Thematic FoFs: Focus on specific themes or sectors by investing in relevant mutual fund schemes.
Advantages for Investors
FoFs offer several benefits that make them attractive to different types of investors:
- Enhanced Diversification: By investing across multiple schemes, FoFs provide broader diversification than single-scheme investments.
- Professional Management: Investors benefit from expertise at both the FoF level and the underlying fund level.
- Convenience: Single-point investment provides access to multiple funds and strategies.
- Risk Management: The multi-layered investment approach helps in better risk management.
- Accessibility: They allow small investors to access high-performing funds that may otherwise require large capital.
Tax Implications
The tax treatment for FoFs in India depends on their underlying investments. Equity-oriented FoFs are taxed similarly to other equity funds, while non-equity FoFs follow the tax rules applicable to their specific asset classes.
- Equity-oriented FoFs: These are taxed similar to equity mutual funds. The Short term Capital Gain is 15% if sold within one year. Long term capital gains Long-term capital gains (LTCG) is taxed at 12.5%. The indexation benefit that investors used to get was removed in Budget 2024.
- Non-equity FoFs: Taxed according to the investor’s income tax slab.
Holding period requirements vary based on the underlying asset allocation
The future of FoFs in India looks promising, driven by several factors:
- Growing Investor Sophistication: Increased understanding of diversification benefits among retail investors.
- Product Innovation: Fund houses continuing to launch specialized FoF products.
- Digital Adoption: Enhanced accessibility through digital platforms making FoF investments more convenient.
- International Diversification: Growing interest in global market exposure through FoFs.
Investment Considerations
Investors should consider several factors before investing in FoFs:
- Investment Objective: Align FoF selection with personal financial goals
- Cost Structure: Understand the dual expense ratio structure
- Tax Implications: Consider the tax treatment based on the underlying funds
- Risk Profile: Assess the risk level of both the FoF and underlying schemes
These schemes offer the investor an opportunity to diversify risk by spreading investments across multiple funds. The underlying investments for a FoF are the units of other mutual fund schemes either from the same mutual fund or other mutual fund houses.
Experts believe fund of funds are generally better suited for smaller investors that want to gain access to a range of different asset classes or for those whose advisers do not have the expertise to make single manager recommendations.
Recent Developments
The FoF landscape in India has seen several significant developments in 2024:
Regulatory Framework: SEBI has implemented new guidelines for FoFs, including:
- Enhanced disclosure requirements
- Stricter investment restrictions
- Improved transparency in expense ratios
- Standardized categorization norms
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Fund of Funds represent an evolution in mutual fund investing, offering investors a sophisticated way to achieve diversification and professional management. As the Indian investment landscape continues to mature, FoFs are likely to play an increasingly important role in portfolio construction. For investors seeking a balanced and professionally managed investment approach, FoFs offer a compelling solution. Their ability to provide diversification across multiple schemes, fund houses, and investment strategies makes them particularly attractive for those who want comprehensive exposure to various market segments through a single investment vehicle.
As we move forward, the FoF category is expected to see continued innovation and growth, potentially becoming a core component of many investors’ portfolios. However, investors should carefully consider their investment objectives, cost implications and tax consequences before incorporating FoFs into their investment strategy.
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