Fund of Funds (FOF): Meaning, Types, and How to Invest

Purchases of mutual funds are common among persons who wish to have their investment managed by professionals besides diversifying. Of all the approaches enumerated the Fund of Funds (FOF) is a type of mutual fund that is quite distinct. It combines capital to buy into as many other mutual funds or hedge funds as possible, thus getting the investor an investment pool that is diversified, professionally managed, and large.

This guide looks at what FOFs are, the different types of FOFs, the pros and cons of FOFs, and how to invest in FOFs to make it easier for investors to understand how the FOFs could fit into the diversified portfolio.

What is a Fund of Funds (FOF)?

Fund of Funds is a mutual fund that will invest in other mutual funds or hedge funds as opposed to investing in individual equities, fixed income, or any other type of investment. This multi-tiered approach adds an extra measure of diversification because it puts funds into multiple funds being managed by different asset managers.

The characteristics of the risk of a FOF depend on the goals and strategies formulated by the portfolio manager. For instance:

High-yield focus: The manager may target funds with high NAV but with more risk that is associated with the investment.
Stability focus: The manager might pick low-risk instruments for stable growth or consistent earnings.

Some of the FOFs can invest locally while others can invest in overseas markets thereby diversifying and depending less on one market.

Key Features of Fund of Funds

Here are the key features of FOF:

Diversification: Due to the pooling of funds, FOFs reduce risk as well as maximize returns through investment in various funds.
Professional Management: Actual professionals manage the FOFs, thus preventing any loss and achieving the best results depending on the market situation.
Accessibility: Some of the FOFs serve to help those with low purchasing power to invest in a diversified portfolio.

Types of Fund of Funds

There are 5 main types of Fund of Funds, as follows:

Asset Allocation Funds: These funds divide securities into different types like equity funds and debt funds and there are funds in metals such as gold. These funds are built with a balance of steady income and high-growth potential to obtain stable returns.
Gold Funds: FOFs that focus on gold buy mutual funds or firms dealing with gold stocks. This is a good strategy for those who seek to possess precious metals in their investments.
International Fund of Funds: These FOFs deal with mutual funds based on foreign markets. They give access to the global markets while utilizing the outcome of foreign equities and debt securities.
Multi-Manager Fund of Funds: One of the most commonly occurring forms of FOFs, these funds pool money and invest the collected amount into many other mutual funds handled by assorted portfolio managers. Every manager focuses on that one segment, increasing competence and return rate within the asset class.
ETF Fund of Funds: Some of these FOFs buy exchange-traded funds (ETFs), and this provides the ordinary investor an opportunity to profit from ETFs without having a Demat account. However, the ETFs are subjected to market volatility risks due to share likeability and similar trading methods as stocks.

How to Invest in Fund of Funds

Investing in FOFs involves a few key steps as mentioned below:

Define Your Goals: Work out your investment goals, your ability to bear an emergency or an adverse event, and the time you are willing to lock your money in a certain investment.
Research the FOF: Conduct a thorough analysis of historical returns, investment type, costs and fees, and personnel managing the fund. Search for funds that come under your goal.
Understand Costs and Taxes: Make sure to know of the higher expense ratios characteristic of FOFs since they tend to have layered management fees. Moreover, get an idea about taxes, especially capital gains.
Choose the Right Investment Mode: It can be purchased through one installment or SIPs based on the investor’s financial capabilities.
Monitor and Review: As an investor in FOF, always analyze the performance of this investment and check if it meets your plans.

Who Should Invest in Fund of Funds?

FOFs are ideal for:

Small-scale investors: Investors with relatively low amounts of cash to invest but still would like to have a diversified stock.
Long-term investors: Those who are willing to set up long-term investments that can ‘lock up’ money for more than a year.
Low-risk seekers: Accomplished investors who would like to achieve portfolio diversification in a bid to lower their overall risk.

Advantages of Fund of Funds

FOFs come with several benefits, like:

Enhanced Diversification: FOFs buy into several funds within and across classes, regions, and industries and thus, balance risk and return.
Professional Expertise: Benefiting from the professional guidance of portfolio managers and well-planned market analysis, FOFs provide much better strategies.
Accessibility: Through FOFs investors get access to high-value funds and international markets regardless of the amount of capital strength they possess.

Limitations of Fund of Funds

There are also certain limitations to investing in FOFs, like:

High Expense Ratio: The inherent hierarchy in FOFs increases managerial costs and hence would reduce net returns.
Tax Implications: Shareholders are charged taxes on gains when they exercise their rights of redemption. Profits resulting from the sale of short-term and long-term capital assets are taxed depending on the income of the investor and the period for which the assets had been held.
Market Volatility: After diversification, FOFs remain sensitive to market changes, which can affect financial results.

Multi-Strategy Funds (MSFs) vs. Fund of Funds

Multi-Strategy Funds (MSFs) are often confused with FOFs, but there are notable differences between the two, as follows:

MSFs are funds managed by a single manager who may manage different strategies within the same fund but FOFs are composed of a variety of managers and funds.
MSFs may offer potentially lower fees and greater flexibility while FOFs focus on spanning across various managers.

Things to Consider Before Investing in FOFs

While there are many benefits to owning FOFs there are also some factors that one has to consider before investing in them.

Liquidity Needs: Since FOFs may take a long term to replenish, make sure you have some source of enough liquidity from other places.
Expense Ratios: Expect to face certain expenses such as management fees at a slightly higher than moderate level.

Conclusion

Fund of Funds remains one of the easiest methods of attaining diversification and professional management. However, their higher costs and probable dilution of returns make their selection necessary to assess adequately. When ascertaining financial objectives, testing funds’ performance, and taking into account possible risks and costs FOFs can become an important element of an investor diversified portfolio.

FAQs

1. In what way do Fund of Funds relate to a long-term investment plan?

While FOFs offer wide diversification and access to professional management they are excellent for stability and long-term growth. Yet, an increase in expenditure can affect the net outcome adversely.

2. Is it possible for a single person to establish their own Fund of Funds?

Yes, investors can diversify their portfolios by investing in different mutual or hedge funds; however, this means spending considerable time and assembling knowledge.

3. Are the Fund of Funds regulated?

Yes, FOFs are regulated by the respective regulatory authority in the country of operation.

4. What impacts does an economic downturn have on FOFs?

On this basis, although they are diversified, the FOFs’ are not immune from market fluctuations. Still, because they are invested in many stocks, the effect is normally cushioned relative to other specific stocks.