Do investors really need fund of funds in their portfolio?

ETF FoFs: These invest in different underlying ETFs

Debt FoFs: These FoFs invest in debt portfolios/funds of different maturity profiles and can take dynamic calls by changing the allocation within the portfolio based on changing interest rates and macro factors.

Equity FoFs: These simply invest in different schemes of different AMCs to provide AMC and multi-manager fund-level diversification.

On the face of it, the concept looks pretty useful. Instead of having to manage multiple funds, your work is done by just investing in one scheme (FoF). It allows you to have a portfolio of other investment funds rather than investing directly in stocks, debt instruments, gold, etc. You get a reasonable amount of diversification, professional curation of underlying funds, ETFs.

But there are few issues as well.

Challenges in FoFs

Since FoFs take exposure to multiple schemes, the overall expense tends to be higher than individual funds. Though there are regulator-specified upper limits on the expenses, these are on the higher side due to the dual layer of expenses – one at FoF level and the other at the underlying scheme level. As per SEBI rules, the total expense ratio that a Fund-of-Fund can charge is currently capped at 2 percent.

Then there is the issue of unfriendly taxation. For taxation purposes, Fund-of-Funds are treated as non-equity funds. So, the short term is defined as up to three years. Accordingly, if sold before three years, your gains are taxed at your tax slab rate, while the long-term capital gain tax is 20 percent with indexation after 36 months.

Note: There is an exception to this taxation rule, though. FOFs with a minimum of 95 percent in equity ETFs have their capital gains taxed as per equity rules.

Another issue with FoFs is that if you are not comfortable with the fund manager’s choices of underlying scheme or handling of allocations, there is no way for you to change them yourself. You are stuck with the fund manager as well as his choices. This might work well for those who don’t want to get into these things. But for those who want to have an active say in fund choices etc., this is a big disadvantage.

One benefit of Asset Allocator FoFs is that when a fund manager changes, there are no taxes as the changes to funds happen within the portfolio of the schemes.

Should you invest in FoF schemes?

Fund of funds are better-suited for smaller investors, or those who have limited know-how and who don’t want to worry too much about the fund choices, asset allocation decisions, etc., and just want to keep one fund in their portfolio. You get to invest in a diversified portfolio using a single fund that you can easily manage with limited funds and can also track the performance easily.

But savvy DIY investors managing their own asset allocation or those who are properly being advised by investment advisors can give these FoFs a miss. They can easily build a diversified and properly allocated portfolio without getting into the FoFs that have their limitations and portfolio-linked restrictions. You also get better taxation that way. But FoFs providing international exposure can still be considered as part of their portfolio by these investors.