Understanding Fund of Funds: How Does It Work?

Imagine you want a beautiful garden but don’t know which plants will thrive best. So, you hire a skilled gardener who carefully selects and plants different types suited to the soil and climate. Similarly, a Fund of Funds invests in a mix of mutual funds chosen by experts to grow your investment wisely.

A Fund of Funds, often called FoF, is a mutual fund that pools investor money and then allocates it across various other mutual fund schemes. These underlying funds can be equity funds, debt funds, international funds, gold funds, or even ETFs. Unlike traditional mutual funds, which invest directly in securities, FoFs focus on creating a well-rounded portfolio by spreading investments across multiple professionally managed funds.

This structure helps reduce the burden of choosing individual funds and provides exposure to multiple asset classes through a single investment.

Let’s understand it step by step. When you invest in a Fund of Funds, your money is not directly invested in stocks or bonds. Instead, the fund manager selects a set of mutual funds based on a specific investment strategy. These selected funds could belong to the same fund house or different ones, depending on the scheme’s objective.

For instance, an international FoF may invest in global mutual funds to give investors exposure to markets outside India. Similarly, an asset allocation FoF might invest in a mix of equity, debt, and gold funds. The FoF manager regularly monitors and rebalances the portfolio to ensure it aligns with the desired risk-return profile. 

Here are some common types of Fund of Funds:

1. Asset Allocation Fund of Funds

Dynamically shifts investments between equity, debt, and other assets based on market conditions.

2. Gold Fund of Funds

Focuses on gold-related mutual funds or gold ETFs to hedge against inflation.

3. International Fund of Funds

Provides exposure to global markets by investing in mutual funds based outside India.

4. Multi-Manager Fund of Funds

Multi-Manager FOFs invest in mutual funds that are each managed by different fund managers or asset management companies.

5. Passive Fund of Funds

These FoFs invest in index funds or ETFs rather than actively managed funds. They offer low-cost exposure to broad market indices, such as Nifty 50 or Sensex, or international benchmarks.

6. Sector-Specific Fund of Funds

Focuses on mutual funds concentrated in specific sectors such as technology, healthcare, or energy. Ideal for investors with a high-conviction view on particular industries but who prefer fund-level diversification within that theme.

• Diversification 

FoFs reduce concentration risk by spreading investments across various funds with different asset classes, geographies, and strategies. 

• Professional Fund Selection 

Fund managers handpick the best-performing mutual funds based on detailed research, which simplifies the decision-making process for investors. 

• Global Exposure 

International FoFs give retail investors access to global markets without the complexity of direct investing in foreign assets. 

• Objective-based Investing 

Many FoFs are structured around long-term financial objectives such as retirement planning, education, or wealth accumulation. 

• Simplified Portfolio Management 

Investors get a diversified portfolio through a single investment, eliminating the need to manage multiple individual funds. 

1. Expense Ratio

Since FoFs invest in other mutual funds, they have two layers of expenses—the expense ratio of the FoF itself and of the underlying schemes. This can make them slightly more expensive than regular mutual funds. 

2. Taxation

• FoFs that invest 65% or more in domestic equities are taxed like equity mutual funds.
• FoFs with less than 65% equity exposure are treated as debt funds.
   

3. Performance Dependence

The returns of a FoF depend entirely on the performance of the underlying mutual funds. A dip in one or more of the invested funds can affect the overall return. 

4. Liquidity and Exit Load

Some FoFs may have exit loads if you redeem before a specified period. Always check the liquidity terms and exit charges before investing.

Fund of Funds can be an ideal choice for:

• First-time investors who want diversification without the stress of choosing individual funds.

• Investors with global aspirations who want exposure to foreign equity or debt markets.

• Busy professionals who prefer a hands-off approach but want professional portfolio management.

• Long-term objective-oriented investors seeking a balanced and diversified investment vehicle for wealth creation.

Fund of Funds brings together the best of diversification, professional fund management, and convenience in one package. Though they come with additional costs, they can be an efficient way to simplify investments and align them with long-term financial objectives. Understanding their structure and purpose can help you decide if they fit your financial strategy.

Explore Fund of Funds options on the HDFC Bank SmartWealth App and start building a diversified portfolio designed for your objectives with expert directions and convenient investing, all in one place. 

Disclaimer: This communication has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. HDFC Bank Limited ("HDFC Bank") does not warrant its completeness and accuracy. This information is not intended as an offer or solicitation for the purchase or sale of any financial instrument / units of Mutual Fund. Recipients of this information should rely on their own investigations and take their own professional advice. Neither HDFC Bank nor any of its employees shall be liable for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including lost profits arising in any way from the information contained in this material. HDFC Bank and its affiliates, officers, directors, key managerial persons and employees, including persons involved in the preparation or issuance of this material may, from time to time, have investments / positions in Mutual Funds / schemes referred in the document. HDFC Bank may at any time solicit or provide commercial banking, credit or other services to the Mutual Funds / AMCs referred to herein. 

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