Five minutes to understanding a fund of funds

Advantages of a FoF
You get better diversification across a product category and across fund managers in an instrument that is not hoping to give market returns, that are given by passive funds with lower costs like index funds, but actively managed funds that aim to beat the market benchmark. An FoF is a good option for somebody who has a one-vehicle-for-all-my-needs approach. A typical portfolio has a mix of debt, cash and equity depending on the investment objective, risk profile and age of the investor. For example, a 30-year-old may want aggressive growth and may want 90 per cent of his portfolio in equity and the rest in debt. He can buy two funds in this proportion, but when markets change, he will need to rebalance his portfolio. This means he needs to track his funds closely and then take the call of rebalancing his portfolio, something that most people find difficult to do. An FoF takes over this decision and will always reallocate the portfolio in the desired proportion as chosen by the investor.

Lower tax cost and loads is another big plus for an FoF. An investor in two schemes – one debt and one equity – would need to pay taxes each time he rebalances his portfolio. For example, if the equity market has risen and the investor needs to sell equity to buy more debt to rebalance, he will have to pay a capital gains tax on his profit when he sells. You will avoid these taxes if you hold an FoF since they are exempt from paying this tax on portfolio rebalancing. You will pay when you exit the FoF. There is also a load advantage to be got in an FoF. Each time you transact in a mutual fund scheme, you need to pay entry and exit loads that total up to about 3–4 per cent of the price. When an FoF rebalances, these loads are not paid, making it cheaper for you.

What are the problems with an FoF?
Annual cost. Not only are you paying the annual investment management fee for the fund that you buy – the FoF – but you are also paying proportionality (according to the per cent of the scheme held) for the management fees of the funds that the FoF buys, making it more expensive to buy than a direct fund. This effect can get cancelled out due to the better performance of an FoF and due to the positive effect of lower tax and load costs that were mentioned earlier.