Investor Corner/The asset classes/Mutual Fund Core Concepts
2.3.14 Fund of Funds (FoF)
A Fund of Funds invests in other mutual funds rather than directly in stocks or bonds. It adds a further layer of cost, but it can be a convenient way to access certain asset-allocation or international strategies.
A fund that invests in other funds
Instead of holding individual stocks and bonds directly, a Fund of Funds builds its portfolio out of units of other mutual funds, which may be run by the same AMC or by a range of different AMCs. This lets a single fund offer diversified exposure across strategies, asset classes or geographies that might otherwise require an investor to research and buy several separate funds themselves.
A Fund of Funds (FoF) is a mutual fund that invests in other mutual fund schemes rather than directly in stocks or bonds. The investor buys units of the FoF, and the FoF's portfolio consists of units of underlying target funds. This creates a two-layer structure: the investor holds FoF units, and the FoF holds units of other funds.
FoFs serve several purposes. International FoFs allow Indian investors to access foreign markets by investing in international funds that the investor may not be able to buy directly. Asset allocation FoFs invest across equity, debt and gold funds according to a predefined or dynamic allocation. Target-date retirement FoFs gradually shift allocation from equity to debt as the target date approaches. Multi-manager FoFs invest in funds from multiple AMCs, diversifying across investment styles and managers.
The extra cost layer
Because a Fund of Funds holds other funds, which each already carry their own expense ratio, the overall cost to the investor typically includes an additional layer of fees at the Fund of Funds level itself. This layered cost structure is the main trade-off to weigh against the convenience and diversification such a fund is offering.
The primary drawback of FoFs is the double layer of expenses. The FoF charges its own expense ratio, and the underlying funds charge theirs. While SEBI has capped the total expense that can be charged by the FoF itself to limit this layering, the investor still bears the cost of both layers. For domestic equity FoFs that invest in other Indian equity funds, this cost layering is rarely justified; the investor can simply buy the underlying funds directly. For international FoFs, however, the structure is often the only practical way for an Indian retail investor to access foreign markets, and the additional cost is the price of access.
Where the structure is genuinely useful
Fund of Funds structures are commonly used for international investing, since they let an Indian investor access overseas markets through a single domestic purchase rather than dealing with foreign accounts directly. They are also used for multi-asset or dynamic allocation strategies, where the underlying mix between equity, debt and gold funds shifts based on market conditions.
How PriLytics helps. PriLytics looks through Fund of Funds and hybrid schemes to show the real underlying allocation, so layered fund structures do not hide what you actually own. See true asset allocation.
Tax treatment of FoFs is an important consideration. A domestic equity FoF that invests in equity mutual fund schemes is not classified as an equity fund for tax purposes unless it meets the 65% equity exposure threshold at the FoF level. Many FoFs, including most international and gold FoFs, are taxed as debt funds regardless of their underlying holdings. This means short-term gains are taxed at slab rate and long-term gains at the applicable capital gains rate, which can be less favourable than the equity taxation regime. Check the fund's tax classification before investing, as this can significantly affect the after-tax return.