1. Types of Fund of Funds
There are many types of FOF, with each investing in a different kind of combined investment scheme. Typically, investors keep the investment-FOF ratio 1:1. They like to invest in regular mutual funds and FOFs simultaneously as the treatment for both regular MFs and FOFs are almost similar but the latter allows them to diversify their portfolio further.
A few examples of Fund OF Funds are:
- Hedge fund FOF
- Mutual fund FOF
- Private equity FOF
- Investment trust FOF
2. Characteristics of FOF
- Fund Availability: FOF schemes are mostly open-ended, so the number of shares or units is not a restriction. You can pick up a share at the face value of Rs. 10 per unit, as these FOF schemes don’t levy any entry load.
- Premature Withdrawal: You can exit prematurely, by paying the exit load levied on prevailing Net Asset Value.
- Liquidity: You can avail purchases and unit redemptions on all business days at NAV based prices, after five business days from the date of allotment of units under the scheme.
- Taxation: The government treats FOF funds the same as debt mutual funds, even if the FOF is investing in Equity based mutual funds. The mutual fund company deducts dividend distribution tax and pays a dividend to the investor. Short-term capital gains are taxed as per the tax slab and long-term capital gains are taxed at 10% without Indexation and 20% with Indexation. Notax on dividend has to be paid by you if it is under Rs. 10 lakh. Income Tax of 10% has to be paid if the dividend is greater than Rs. 10 lakh.
- Minimum Investment: Different FOFs schemes have different minimum investment amounts. It’s recommended that investors start a Systematic Investment Plan (SIP), to counter market volatility. FOF schemes offer both the dividend option and growth option. If you opt for the dividend option, you can use the payout for reinvestment.
3. Benefits of FOF Investment Strategy
Here are some of the benefits of investing in FOF:
- Greater Gains: Mutual Fund companies typically invest in a small range of securities and control them directly. With the FOF strategy, investors can invest in a collective investment scheme that can increase fund diversity, and benefit from greater gains when compared to typical investment strategy.
- Diversification: Diversification is FOF’s most basic function, as FOFs are designed to achieve better diversification than traditional mutual funds. A single FOF investment could get a savvy investor diversified portfolio that comprises of debt, money market, bonds, and gold or equity investments.
- Reduced Efforts: FOF reduces the investment efforts that investors put out to select the right fund schemes for their portfolio. It’s the job of the fund house to weigh all the underlying funds; so, with the help of an excellent fund house, investors can invest in FOFs fairly safely.
4. Shortcomings of the FOF Investment Strategy
- Increased Management Fees: Investors have to pay increased Management Fees that are much more than what one would pay on traditional investment funds. This is because the FOF Management Fees include the fees charged by the underlying funds. So after allocating the Management Fees at all levels and paying the tax on the investment, investors of FOF investments obtain lower yields than if they invest in single-manager funds.
- Too Much Diversification: FOF might invest in hundreds of funds at a time. Over time, a FOF can become so diversified that it becomes almost impossible to beat the market odds. For example, a FOF of 20 funds, with each holding 50 stocks could own up to 1,000 investments (if there is no overlap between the positions of the underlying funds). Given this level of diversification, investors of the FOF would most likely be better off owning a low-fee index fund that comes at a substantially reduced price but offers vast diversification.
- Hard to Keep Track: A single FOF buys several different funds, which again invest in many different stocks. So, at the end, it’s possible that FOF owns the same stock through several different funds. For the investor and the fund house, it can be very hard to keep track of the overall holdings.
Despite its high investment fees, Funds Of Funds is great for medium-to-long-term investment. Carefully study the terms of the scheme before investing your money. Be sure to select well-known funds that hold good reputations for fiscal strength. While investing in FOFs, maintain a long-term horizon in order to beat inflation and get better returns.