A Fund-of-fund (FoF) is a mutual fund scheme that constructs a mutual fund portfolio instead of investing directly in stocks, bonds or commodities.

There are different types of FoF in the market.

Asset allocation Fund-of-Fund

Asset allocation funds typically invest in a variety of asset classes – equity, debt and gold. In a fund of fund structure, investments are done in a mixture of equity, debt and gold funds. By investing in a single FoF, investors’ asset allocation needs may also be addressed.

International Fund-of-Fund

 While some fund-of-funds are index funds investing in popular international indices (say US S&P 500), others act as a feeder to actively managed international funds.

Multi-manager Fund-of-Fund

You can diversify your investments across different professional managed funds by investing in a single multi-manager FoF. Here investments are typically made in schemes of different asset management companies to hedge fund manager risk.

Gold Fund-of-Funds

Gold FoF invests either in Gold Exchange-Traded Funds (ETF) or funds that buy shares of gold mining companies.

Besides, there are debt and equity Fund of Funds that invest in debt and equity funds respectively, while ETF FoF invests in varied underlying ETFs.

Here, are some of the FoF advantages:

Ease of operations

In the initial years, when savings might be hard to come, multi-manager FoF can provide the necessary diversification as well as convenience.

Also, there are some tax advantages; especially when you have to sell a non-performing fund or tweak asset allocation. There are no tax liabilities for FoF investors when its fund manager rebalances portfolio – by selling or buying new equity or debt funds.

Saving Demat and other costs

If you want direct exposure in international equity markets or want to invest in ETFs, you need to have a trading and demat account. It entails recurring costs and unless you are an active trader, it might be prudent to go for an FoF. FoF facilitates investments into ETFs as well as international markets whereby the FoF hold ETFs or units of international funds, which in turn invest in international shares or bonds.

Investing in a Fund-of-Fund has its own challenges too

High expense ratio

The Fund of Fund structure implies costs at two levels for the investor – one charged by the FoF and the other charged by the underlying mutual fund scheme. As per SEBI rules, an FoF can charge up to 1% p.a as its expense ratio. It is over and above the annual expenses of its constituent fund. And if the underlying schemes are actively managed, then respective caps apply based on the asset allocation of the fund.

Portfolio Duplication

Investing in a portfolio of schemes doesn’t necessarily mean optimal diversification. What if the FoF has five schemes and their portfolio resemble each other a lot? It will only lead to portfolio duplication. And in an FoF, there is always a high probability of overlapping of assets or instruments.

Tax Issues

FoF is categorized as a debt-based scheme for tax purposes even if it might be primarily investing in stocks. It has tax implications. The Long-Term Capital Gains (LTCG) tax for equity schemes is 0% for gains made up to Rs 1 lakh in a financial year.

In a debt scheme, LTCG rates become applicable after holding units for three years instead of one year for equity-oriented schemes. Moreover, LTCG rates for debt-based schemes are 20% (after providing for indexation benefits) while Short-term Capital Gains tax is 30%.

Limited Choice

There are only a few multi-manager FoF that actually invest in schemes of other fund houses. Rest have a strategy to invest in-house and within their funds – which may not always be a good option.

Should you invest?

If you are just starting to invest and are doing it yourself, FoF is a good beginning. Moreover, for exposure to international equities or ETFs, FoF are the convenient way.  However, if are seriously chasing your financial goals and building a portfolio, you might as well take the help of a financial advisor in the creation of a customized portfolio of funds.

Fund of Funds can be a good way to gain exposure to US equity for your long term portfolio. Here's how Scripbox can help you invest in such a fund.