By compiling a portfolio of securities, mutual funds offer investors the benefit of diversity. Investors can choose from various types of mutual funds depending on risk tolerance, expected returns, investment budget, etc. And fund of funds is one of the many mutual fund options accessible to investors.
What is a fund of funds?
A Fund of Funds (FoF) is a type of mutual fund that invests in units of other mutual funds. So, instead of directly investing in securities such as stocks and bonds, an FoF invests in other mutual fund schemes. These schemes can be by the same mutual fund house or other fund houses. FoFs can invest in domestic mutual funds as well as international funds. An FoF’s investment purpose determines which schemes it invests in.
An FoF seeks to maximise portfolio diversification while reducing overall risk. The approach adopted by FoFs allows investments across various fund categories, bundling them into a single portfolio to achieve broad diversification and proper asset allocation. FoFs essentially use the strategy of multi-manager investing where the FoF consists of several specialised funds, each managed by a different manager and using a different investment strategy.
Benefits of fund of funds
Diversification
A fund of funds targets the best-performing mutual fund schemes in the market, each focused on a specific asset class. Due to the underlying portfolio variety, returns and risks are optimised, and there is the potential to earn better gains through diversification.
Tax efficiency
Investors who want to rebalance their holdings won’t be subject to capital gains tax on this internal transaction. Therefore, there won’t be a capital gains tax when the fund of funds is rebalanced to maintain the stated proportion between debt and equity.
Capital investment
Investors get access to the best mutual fund investment on a national and international level through funds of funds. This provides access to a wide variety of investments across geographies at a relatively lower cost. As a result, investors with smaller investment budgets can also use this tool to increase their profits by adding FoFs to their portfolios.
Lower risk
FoFs are suitable for conservative investors as the high level of diversification offered by them reduces the investment risk. The diversification is not only across multiple asset classes and securities but also across multiple investment strategies and fund houses.
Conclusion
Investors who invest in a fund of funds theoretically have unlimited access to various securities and assets. These funds give investors access to index funds, exchange-traded funds, international funds, etc., while also allowing them to profit from passive investments.
Before you invest in an FoF, you should carefully look at the asset allocation and portfolio of the fund and see the kinds of mutual fund schemes it has invested in. It’s essential for the FoF to align with your risk tolerance and financial goals and fit into your larger investment strategy.