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Reduce risks: Invest in multi-manager funds

Mutual fund investments have gained a lot of popularity in the last two decades, primarily for its ability to reduce risks, provide greater diversification and beat market volatility to a certain extent. But with a plethora of schemes available in the market, how does one choose the right one or diversify among the different schemes?

The answer could well be in a scheme called 'fund of funds' offered by some fund houses. InvestmentYogi brings out the key features of this product, to help investors understand its working and the value it could bring for them.

What is a fund of funds (FoF)?

In simple words, a fund of funds is a mutual fund which invests in other mutual fund schemes. Where a traditional mutual fund comprises of a portfolio of shares, a fund of funds comprises of a portfolio of different mutual fund schemes.

The units held by a FoF scheme would be similar to a traditional mutual fund scheme, with the difference that, they are invested in units of other mutual funds, instead of direct stocks. A FoF helps the investor to reduce his chances of selecting the wrong mutual fund.

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How does a fund of funds work?

The process of investing in fund of funds is similar to investing in other mutual funds. For the amount invested, units are allocated on the basis of the NAV of the scheme.

The performance of the FoF is linked to the NAV movement of the underlying mutual fund scheme, in which the FoF has invested.

Fund of funds invest in mutual funds on the basis of an investment objective, such as aggressive, conservative etc. The right fund to invest in is chosen by the fund manager.

The primary objective of FoF is to provide greater diversification, at reduced risks and ease the process of fund selection for investors. Fund of funds however bears all the risks of the underlying mutual fund they invest in.

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Advantages of investing in fund of funds

Here is why investing in fund of funds would be beneficial to investors:

Diversification

Investing in a FoF scheme provides the investor greater diversification. A single investment could get the investor a diversified portfolio comprising of equity, debt, money market, bonds or gold. With greater diversification, a FoF scheme hedges investor risk across various sectors.

In principal, all eggs would not be put in one basket.

Switching between funds

In a traditional mutual fund investment, any switches or rebalancing between funds would attract a capital gains tax and an exit load for the investor. In a FoF investment, the investor would not be burdened with such costs, as the fund manager would automatically switch between funds, in line with the investment objective of the scheme.

Simplicity of investing

An investor need not keep track of multiple mutual fund schemes and their performances. Investors would have only one folio to maintain and one NAV to keep track of.

Affordable investment

New or first time investors, who do not have large capital for a diversified portfolio, could now diversify from among thousands of funds and stocks, with a small amount of money.

Benefits from institutional investments

Many funds are generally not accessible for retail investors such as top tier funds or closed ended funds. With the FoF scheme, an investor gets access to such funds which are otherwise off limits for small investors.

Reduced risk

In a traditional mutual fund investment, it is the capability of the fund manager to choose the right stock to invest in, for the fund to perform well. With a FoF investment, this risk is reduced for investors who now have their portfolio exposed to investment strategies of various fund managers.

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Disadvantages of fund of funds

Cost to investor

Expense fees and management costs are higher than normal mutual funds, as the cost structure will include the fees of the underlying mutual funds, as well as the FoF.

Investments in same stocks

The schemes in which the FoF invests in, in turn invest in different stocks. There is a possibility that the FoF may be holding the same stock through different funds it has invested in. Thus any adverse movement of this stock could affect the FoF performance.

Tax implications

The tax treatment on fund of funds is similar to investments made in debt mutual funds, even if the scheme is investing in equity based mutual funds. The investor will have to bear a dividend distribution tax similar to a debt mutual fund.

Thus, if you are a mutual fund investor and are unable to take informed decisions then fund of funds could be the ideal choice for you. Many investors lack the time, inclination and expertise to monitor the market or mutual funds. In such cases too, fund of funds comes as the perfect investment tool.

*Past Performance of a Few FoF Schemes (as on 18 August 2010)