How Do Fund of Funds (FOF) Strategies Function?

What if you could depend on multiple fund managers and their collective wisdom rather than depending on one fund manager’s expertise with your hard-earned money? 

What if you could invest in various mutual fund categories simultaneously by investing in a single mutual fund scheme? Like sectoral thematic funds or hedge funds that are usually out of reach for investors with a limited budget. 

By investing in a single mutual fund scheme, you could hold a bouquet of portfolios with diverse underlying assets and maximise profit. No need to worry if the Pharma sector fund you invested in recently will generate expected returns or if the infrastructure sector fund will continue to rise amid the new government regulation. 

This is what a Fund of Funds (FOF) offers.  

How does a fund of funds work?

As its name suggests, FOF is a type of fund that invests the pooled money across a variety of mutual fund schemes like ETFs, hedge funds, index funds, sectoral, thematic funds, etc. But it does not directly invest in bonds, stocks, shares, or other securities.

To understand how FOF functions better, consider the following example.

Assume you have invested in five different mutual funds. A is a sectoral mutual fund, B is a real estate fund, C is a thematic fund, D is an Exchange-Traded Fund (ETF), and E is an index fund. While all these funds are professionally managed, keeping a tab on how each fund is performing can get confusing and taxing for the investor on their own. This is the hassle a fund of funds eliminates structurally.

As a multi-management investment strategy, FOF thrives on the collective wisdom of different fund managers. It invests the pooled money across diverse funds. Whether there are equity sectoral funds performing well at the time or some thematic funds expected to boom – FOF will identify and bank on all such growth opportunities.

How? Through two broad investment strategies –

1. Diversification: Since FOFs hold a broad mix of mutual funds like sectoral and thematic funds, they provide a highly diversified portfolio. This spreads the risk across different assets and brings down the overall risk involved in the FOF portfolio-as-a-whole.

Besides, FOFs offer a double layer of diversification. They invest in a diverse mix of funds that have invested in diversified securities. Hence, the overall risk is reduced. But despite the reduction, the returns don’t take a hit. The ‘low risk, low reward’ equation is overturned here.

2. Asset allocation: While FOFs use diversification to reduce risk, they use the asset allocation strategy to balance the risk-reward equation. Therefore FOFs can pool money across high-risk instruments like equity-oriented mutual funds or sectoral mutual funds.

Beyond that, FOFs also put money into closed funds that are not directly accessible to investors with a small budget. This ensures good returns over the long run.

To summarize, a fund of funds works on the principle of broad diversification and dynamic asset allocation. As a result, they offer decent returns to investors with a low-risk appetite. 

But -- is a fund of funds a safe investment? 

Like every mutual fund scheme, different FOFs also operate with varying degrees of risk. Sectoral thematic funds, for example, have 80-90% of the pooled money invested in equity instruments and carry a concentration risk. So, if a FOF has invested across many sectoral and thematic funds, the fund will have a high risk.

Likewise, if most of the FOF portfolio contains high-performing sector funds, the risk will remain high. However, higher stakes also promise higher returns, so that’s a bargain investor have to make.

On the other hand, if the FOF essentially comprises funds with underlying assets in debt and bonds, it is considered less risky.  

Besides, you can easily tolerate high-risk mutual investments like sectoral and thematic funds if you have a longer time horizon. And FOFs are targeted towards investors with time to spare. 

To illustrate, many sectoral mutual funds, as well as thematic funds, have historically given excellent returns to long-term players. Even if there are losses, they are usually balanced over time. In that sense, no FOF is risky if you can handle it well. 

Nevertheless, at the end of the day, you will have to choose a FOF aligned to your risk appetite and rewards expectations. 

Also, don’t forget to consider FOF classification

The underlying funds of the FOF (no matter the type - equity sectoral funds, index funds, gold funds, thematic funds, etc.) may or may not be managed by the fund house operating the FOF. 

If the FOF invests in funds managed by its own fund house, like thematic funds, liquid funds, or sector funds, then the scheme is termed “fettered.” In contrast, if the investments are in funds outside of its fund house, the FOF scheme is called “unfettered.”

This is vital to know when deciding on a FOF scheme for investment, apart from the degree of risk, of course. 

Consider the FOF portfolio and its fund house carefully. What is the past performance of the growth funds or the sectoral mutual funds they are holding? Is the portfolio risk aligned with your appetite? Your returns from the FOF scheme will boil down to all of these factors and more.  

Before you go

Given the scope of FOFs — should you invest in one?

Ideally, FOFs are best-suited to new investors with a longer investment horizon and a low-risk appetite. Since they lack the proper knowledge to make strategic direct investments, they can bank on the fund manager’s expertise and book consistently good returns. However, FOFs generally charge a higher service fee given the professional expertise offered.

Does the investor description sound like you? Then start your mutual funds journey with Moneyfy – a one-stop destination for MF investments. Explore different types of investments, compare mutual fund schemes based on your goal, check fund managers’ track records, or scout fund categories.

Check out the Moneyfy app today.