If you’re looking to diversify your investments but don’t feel confident about your knowledge about a range of assets, Fund of Funds may be the way to go. Read on to learn all about them and their advantages and disadvantages.
Introduction to Fund of Funds
As the name suggests, a Fund of Funds (FOF) is used to invest in other mutual funds. They offer to achieve wider opportunities for diversification, and there are fewer risks. The managers of such funds focus on small investors who want more exposure with minimal risk.
FOF is a mutual fund that helps invest in domestic and international funds of better Asset Management Companies (AMCs). Such funds are sometimes used to train people as portfolio managers.
Understanding the basics and purpose of fund of funds in investment management
The main purpose of the FOF is to offer better returns, of course. Anyone with access to small financial resources can use this option to ensure access to higher-value funds. It also enables one to earn maximum returns at less risk.
These funds, therefore, help achieve the following purposes:
- Asset allocation
- Exposure to ETFs
- Reduction of the tax burden
What is a fund of funds?
FOF is a mutual fund combining schemes to offer perks such as lower time frames and risks. Combining different schemes translates into benefits such as diversification. Such funds are known as multi-manager investments.
An explanation of the definition and concept
These funds let you, as an investor, invest in other mutual funds, including index funds and ETFs. They are the most common investment fund, offering better returns and diversification benefits.
These funds allow investors with limited capital to progress and create diversified portfolios. It thus offers a kind of professional wealth management service that every investor can access.
Types of fund of funds
There are many types of fund of funds. The different types depend on the type of funds they invest in and their focus.
A classification of different forms and their characteristics
- Asset allocation funds: This type of fund flows into a diverse asset pool of equity, debt instruments, precious metals, etc. The diversity of this investment helps generate high returns at a reduced risk level. The relatively stable securities present in the portfolio help reduce the risk.
- Gold funds: These mutual funds invest in gold mutual funds, which trade in gold. They can also have a portfolio of gold trading companies.
- International fund of funds: Mutual funds that operate internationally are the focus of these funds. Investors can get higher returns with it, as this fund offers exposure to other countries’ best-performing stocks and bonds.
- Multi-manager fund of funds: This is the most common type of fund of funds. These funds have an asset base comprising various professionally managed funds—each with a different portfolio configuration. This fund of funds gets its name because it has multiple portfolio managers for specific assets.
- ETF fund of funds: Exchange Traded Funds (ETFs) are a popular investment tool. ETFs are more accessible than direct investments, which require Demat accounts. They are slightly higher-risk assets.
How funds of funds work
The main purpose of a fund of funds is to increase returns while minimizing the risk factor. How they work can be broken down into the following steps.
A step-by-step overview of the investment process
- There are several types of FOFs. Each operates according to its specific investment strategy.
- A FOF can be set up as a hedge fund, private equity fund, investment trust, mutual fund, or private equity fund.
- The FOF may or may not be restricted. A restricted fund only invests in assets that a single investment company manages. You need to learn about the type as well as the fund manager.
- The fund manager then collects the funds and pools them into various mutual funds.
Advantages and disadvantages of fund of funds
Like all things in life, there are many pros and cons of investing in FoFs. Let’s take a look at them in the following concluding section.
An analysis of the pros and cons of investing in fund of funds for investors
The advantages of investing in FOFs are:
- A fund of this kind focuses on small investors who need to get more exposure with minimum risk. That’s a win for small investors.
- Investing in FOFs allows investors to create diversified portfolios.
- Most FOFs demand proper background checks of portfolio handlers, so the chances you’re safe are higher.
The disadvantages of investing in FOFs are:
- The investment costs are often greater than those of regular investment funds (possibly due to the compounding effect). As a result, the profits from FOFs might reduce.
- FOFs also have a yearly operating expenditure known as the expense ratio and other operational expenses.
- Investors have to pay the tax on a FOFs only during the redemption of the principal amount. However, both short-term and long-term capital gains are subjected to tax deductions during recovery. This can be quite burdensome, even though the manager pays the dividend tax.