Fund of Funds: Should these be in your portfolio

28 Mar, 2021

7 min read

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Imagine that you wanted to install a new switch board in your room when the work from home craze started after the lockdowns.

Imagine that you wanted to install a new switch board in your room when the work from home craze started after the lockdowns. You could perhaps accomplish this task in two ways. In the first one, you would have to make measurements for how much wire you would need, you would have to buy the switch board, the switches, the wires that would be needed in connecting these switches to the sockets - perhaps a few screws and adhesive tapes - and of course, an electrician. But what if the wires were available only in multiples of ten metres while you needed only one or two? And what about other materials like switches and boards - what if they were available under a bulk packaging too? Well, another way you could do this - and you probably have - is to outsource everything to an electrician - he analyzes the situation, buys the material for you (if he doesn’t already have it) and works out the installation on his own!

Funds of funds can be easily understood by this very analogy - as an investor, you might be interested in investing equity, and consequently, you might end up investing in mutual funds. But how many mutual funds to invest in? What about the fund manager, are they qualified enough to be managing your funds? Do you have enough money to invest in multiple funds, or can you afford to invest only in one or two - or even three of them? This is where funds of funds will come to your help - because a fund of funds will help you diversify your investment across multiple mutual funds without you having to worry about the entry barriers, the credentials of fund managers and an under-diversified portfolio.

In sum, funds of funds help you invest across multiple mutual funds and they ensure that your investment has undergone due diligence. In addition, they give you an opportunity to diversify beyond the limits that the capital at your disposal might subject your investment to. What does that mean? Well, when you are investing in multiple mutual funds, you might have to meet their individual minimum amounts of investment in order to be able to diversify across multiple assets. FOFs help you get rid of this limitation, and can diversify your portfolio beyond your reach. Well, it sounds good so far. So why is everyone not investing in them already?

Because there are a few drawbacks to FOFs too. Imagine that you had zero restrictions on the amount you could invest in a fund. In this way, you could invest your hundred rupees across hundred different funds, each of which themselves invest across a number of securities - like stocks, bonds, real estate, metals commodities, etc. However, beyond a well-optimized mix of funds, this approach to diversifying might take you south - because you might discover that multiple funds have overlaps between the securities they invest in. Some FOFs might be subject to this problem.

In addition, FOFs might end up eating your profits. Why? You might be familiar with how mutual funds charge you for making money for you off your money - that is, through performance fees and management fees. Well, the same occurs in FOFs on two levels. First, by investing in FOFs, you will pay the management and performance fees of all the underlying funds, and in addition, you will also pay the same for the FOF too. This might take up a sizable chunk of your profits in addition to the tax implications that your investment will be subject to.

Next, FOFs might subject you to exit implications including lock-in periods. While such measures are put in place to safeguard the company from multiple concurrent withdrawals, this can prove harmful for you in times when only a select few sectors are performing well, and the general economy is undergoing a slowdown. If you had invested in multiple funds, you could simply divest and add your funds to the ones which expose your money to the well-performing sectors.

Lastly, the performance of FOFs can be affected by subtle microeconomics that underpin the management process. For example, if the fund managers are being paid a chunk of the assets under management or profits from performance fees, then they might take a strategy that benefits them more - exposing the funds to short term capital gains implications and trading fees.

Well, so who should invest in FOFs and why, if they are subject to these drawbacks? Like with other investment opportunities, FOFs come with their own bag of advantages and disadvantages. Whether this unique mix tilts the needle of FOFs in your favour and benefit or not will be up to you to decide. However, FOFs might just hit the sweet spot for some types of investors. For example, consider that a couple in their fifties wants to expose their savings to the equity market, and they want to retire within the next decade.

For such investor profiles that are looking to realize better gains on their investments than traditional instruments but still occupy a conservative position on their risk tolerance, FOFs might become the instrument of their choice. Moreover, for people looking to expose their funds to multiple markets beyond their own national borders, FOFs can simplify the investment process and defer the responsibility of market diligence and portfolio management onto more experienced managers. Like all investment opportunities, FOFs will suit a particular profile of investors depending on their goals and their take on risk and reward from their personal investments.

Learn more about emerging avenues of investment in depth - log on to www.angelbroking.com to find out more!

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