How a Fund of Funds can help diversify your portfolio

Ideally, your mutual fund investment portfolio should comprise different kinds of funds depending on your risk profile, investment objective and time horizon for the goal. Investing in more than one kind of fund is also essential for diversification, which is a basic tenet of investing. One way of diversifying is by including a Fund of Funds in your portfolio.  Let us see how a Fund of Funds works and what to keep in mind while investing in one.

Fund of Fund Schemes

The Fund of Funds (FoF) scheme is a mutual fund scheme that invests the pooled resources in other schemes – either from the same fund house and/or different fund houses – based on the investment mandate. So, you essentially get the benefit of investing in multiple funds by investing in one fund. 

A FoF scheme may invest in domestic funds, i.e. in their home country and/or offshore schemes, also known as international fund of funds –– again, based on its investment mandate. Instead of a portfolio of stocks, debt, and money market instruments, the portfolio of a FoF could comprise a range of mutual fund schemes in various compositions.

By investing in this one fund, you can gain exposure to multiple mutual fund schemes managed by various fund managers. The regulatory norms mandate a FoF scheme to invest a minimum of 95% of the scheme's total assets in the underlying fund/s.

Mutual fund houses offer FoFs in various forms, viz. Equity Fund of Funds, Multi-manager Fund of Funds, Asset Allocation Fund of Funds (also known as Multi-Asset Fund of Funds), Global Fund of Funds, Life Stage or Managed Solutions Fund of Funds (for people in different age brackets looking at financial planning), Debt Fund of Funds, and Gold Funds (investing in an underlying gold ETF), etc.

The advantages of a FoF scheme are:

• You can invest a small amount and potentially enjoy the benefits of optimal diversification.
• You benefit from a variety of investment styles and strategies followed by fund managers of the underlying mutual fund schemes of the FoF.
• Reduces the hassle of maintaining multiple accounts/folios, and tracking multiple investments.
• Makes portfolio review and monitoring easy, as you avoid overcrowding your investment portfolio.
• To invest in certain international opportunities or themes, a FoF may be the only option for retail investors.
• The transaction cost is lower since you invest in one fund, as opposed to investing in multiple funds. 
• It softens the tax impact at the time of rebalancing the portfolio. If, for instance, you were to move a particular scheme out of your portfolio due to its underperformance and invest in another scheme, you would have to pay the applicable tax. But in a FoF, when the fund manager moves the money from one fund to another, there is no tax liability on the investor.

[Also Read: How to minimize your mutual fund losses]

However, there are some disadvantages too.

• Higher expense ratio: The expense ratio for a FoF scheme could be higher, depending on its type. This is because, effectively, the expenses are charged at two levels: 1) at the Fund of Funds level, and 2) by the underlying investment schemes.
• Taxation rules differ from mutual funds:
  For taxation purposes a FOF could be equity oriented or debt oriented. For a FOF to be classified as equity oriented for taxation purposes, it should invest a minimum of 90% in the units of another Exchange Traded Fund which again invests a minimum of 90% in the equity shares of listed domestic companies. Rest all FOFs are considered as ‘non-equity oriented’ or a debt scheme for taxation purposes and taxed accordingly.
  
  If you redeem such a FoF scheme that is recognised as non-equity from a tax angle within 36 months from the date of investment, a Short Term Capital Gain (STCG) tax will be levied. The STCG is taxed as per your income tax slab rate along with the applicable surcharge plus health and education cess applicable for that financial year. On the other hand, if you redeem it after 36 months or more from the date of investment; it would attract Long Term Capital Gain (LTCG) tax @20% with indexation benefit, i.e. after adjusting for the Cost of Inflation Index (CII).
  
  But if it is recognised as an equity-oriented FOF (from a tax angle), the holding period for taxation is 12 months. If the units of such a scheme are redeemed within 12 months from the date of purchase, STCG Tax will be levied. Whereas if the units are redeemed after 12 months from the date of purchase, LTCG tax @10% will be levied (without indexation benefit) on the gains over Rs 1 lakh. The limit of Rs 1 lakh is for the total LTCG in a financial year.
• The risk of one underlying scheme underperforming could weigh on the overall performance of the FoF: Given the structure of the FoF, if the underlying mutual fund scheme of the portfolio of the FoF falters on delivering returns, there is a risk of it dragging down the overall performance of the FoF. Hence, paying attention to the portfolio characteristics is important.

Who should invest in FoF schemes?

You could consider a FoF scheme if you are looking for a diverse investment portfolio that is not too complex, have a small amount to invest and want to benefit from different fund management styles.

Select the FoF scheme/s by studying the investment mandate, its performance track record, and evaluating whether it matches your requirements. Click here to pick one.

Disclaimer: This article is for information purpose only. The views expressed in this article are personal and do not necessarily constitute the views of Axis Bank Ltd. and its employees. Axis Bank Ltd. and/or the author shall not be responsible for any direct / indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision

Mutual Fund investments are subject to market risk, read all scheme related documents carefully. Axis Bank Ltd is acting as an AMFI registered MF Distributor (ARN code: ARN-0019). Purchase of Mutual Funds by Axis Bank’s customer is purely voluntary and not linked to availment of any other facility from the Bank. *T&C apply