Fund of Funds (FOFs): Meaning, Types, Advantages & Disadvantages

Investors often seek diversified investment avenues to manage risks and optimise returns. Fund of Funds (FOFs) emerge as an innovative investment approach that offer a unique proposition by investing in a portfolio of other funds. Understanding the concept, types, advantages and disadvantages of FOFs is crucial for investors exploring diversified and professionally managed investment options. This guide explores the meaning, various types and the pros and cons associated with FOFs to assist investors in making informed decisions and maximising their investment portfolios.

Understanding Fund of Funds in detail

Fund of Funds refers to an investment strategy where a Mutual Fund or an investment company pools capital from investors to invest in a portfolio of other investment funds, instead of directly investing in individual securities. This approach enables investors to gain exposure to a diversified array of asset classes and investment styles through a single investment vehicle.

FOFs come in various forms, including those investing in Mutual Funds, Hedge Funds, Exchange Traded Funds (ETFs) or a combination of these. These funds can focus on specific strategies like growth, income or sectoral themes, catering to diverse investment objectives.

The primary advantage of FOFs lie in their inherent diversification, offering access to a broad range of underlying funds, thereby spreading risks across various asset classes or sectors. Additionally, FOFs provide professional management, allowing investors to leverage the expertise of fund managers in selecting and managing underlying funds.

However, FOFs also carry certain drawbacks, such as the layering of fees, as investors are subject to fees at both the FOF and underlying fund levels, potentially impacting overall returns. Moreover, the complexity of multiple layers of investment management can sometimes make it challenging for investors to assess performance or understand underlying fund strategies.

Types of FOFs

Fund of Funds (FOFs) include various types, each tailored to specific investment goals and strategies:

1. Multi-Asset Fund of Funds: These FOFs allocate investments across asset classes like equities, fixed income, commodities and real estate funds. They aim to create a diversified portfolio, balancing risk and return by spreading investments across different asset categories.

2. Hedge Fund of Funds: These FOFs invest in a portfolio of Hedge Funds rather than directly in stocks or bonds. They provide access to alternative investment strategies employed by Hedge Funds, aiming for higher returns or risk mitigation.

3. Single strategy Fund of Funds: Focused on a specific investment strategy, these FOFs invest in various funds employing a singular approach, such as growth-oriented funds, income funds or value-oriented funds. They aim to capture returns from a particular strategy.

4. Regional or geographic Fund of Funds: These FOFs concentrate on investments within a specific geographic region or country. For example, an Asia-Pacific FOF might invest in funds focused solely on the Asia-Pacific region, offering exposure to regional market opportunities.

5. Sector-specific Fund of Funds: These FOFs concentrate on a particular sector or industry, such as technology, healthcare or energy. They invest in funds specialising in specific sectors to capitalise on sector-specific growth potential.

6. Passive Fund of Funds: These FOFs invest in a portfolio of Index Funds or Exchange Traded Funds (ETFs) to replicate the performance of a specific market index or benchmark. They aim to match the returns of the index they track.

7. Active Fund of Funds: Contrary to passive FOFs, these actively managed FOFs involve fund managers actively selecting and adjusting underlying funds. The objective is to outperform the market or a specific benchmark by making strategic investment decisions.

Advantages of investing in FOFs

Investing in FOFs provides several advantages for investors:

1. Diversification: FOFs offer inherent diversification by spreading investments across various underlying funds or asset classes. This diversification helps mitigate risk by reducing the exposure to any single investment, thereby enhancing portfolio stability.

2. Professional management: FOFs are managed by professional fund managers with expertise in selecting and managing underlying funds. Investors benefit from the expertise and experience of these managers, who actively monitor and rebalance the portfolio to optimise returns.

3. Access to diverse strategies: FOFs provide access to diverse investment strategies, asset classes and fund managers that might not be easily accessible to individual investors. Investors gain exposure to various investment opportunities through a single investment vehicle.

4. Risk mitigation: FOFs potentially reduce the risk associated with individual fund selection. By investing in a basket of funds, FOFs can help minimise the impact of underperforming funds within the portfolio, thus reducing overall investment risk.

Disadvantages of investing in FOFs

1. Costs and fees: FOFs generally come with additional layers of fees. Investors might face the fees associated with the FOF itself and the fees of the underlying funds within the portfolio. These cumulative expenses can eat into overall returns, potentially reducing the net gains for investors.

2. Potential over-diversification: While diversification is a key advantage, excessive diversification within FOFs could lead to over-diversification. This might limit the potential for significant gains from individual high-performing assets within the portfolio, diluting the impact of outperforming funds.

3. Performance dependency: FOFs' performance heavily relies on the performance of the underlying funds and the fund manager's selection abilities. If the chosen underlying funds underperform or the fund manager fails to select top-performing funds, it can negatively impact the FOFs’ returns.

4. Lack of control: Investors in FOFs have limited control over selecting and allocating underlying funds. The fund manager's decisions dictate the fund's composition and strategy, leaving investors unable to tailor the portfolio to their specific preferences or adjust holdings based on changing market conditions.

How to invest in FOFs

Investing in FOFs involves a straightforward process similar to investing in Mutual Funds or Exchange Traded Funds (ETFs). Here's a step-by-step guide on how to invest in FOFs:

1. Research and selection: Begin by researching different FOFs available in the market. Evaluate their investment objectives, portfolio composition, historical performance, expense ratios and risk profiles. Choose FOFs that align with your investment goals and risk tolerance.

2. Choose an investment platform: Identify the financial institution or bank in which you wish to invest the FOFs.

3. Open an account: If you don’t have an account with the chosen platform, open an investment account. This may involve providing personal information, completing necessary forms and agreeing to relevant terms and conditions.

4. Fund selection: Once your account is set up, select the specific FOFs you want to invest in, based on your research and investment strategy.

5. Investment amount: Decide the amount you want to invest in the chosen FOFs. Different FOFs may have varying minimum investment requirements, so ensure you meet the applicable criteria.

6. Place your order: Use the investment platform's interface to order the selected FOF units. Specify the amount or number of units you wish to purchase and confirm the transaction.

Conclusion

Fund of Funds (FOFs) offer diversified investment avenues via a single vehicle, with various types catering to diverse objectives. Despite advantages like diversification, their layered fees and dependency on underlying funds require careful consideration to make informed investment decisions.