InvestorQ : What are the fund of funds and what are the disadvantages?
Swapnil Sarang made post

What are the fund of funds and what are the disadvantages?

Rishita Das answered.
1 year ago

A Fund of Funds (FOF) is an investment vehicle where a fund invests in a portfolio composed of shares of other funds rather than investing directly in stocks, bonds, or other securities. The strategy of investing in a fund of funds aims to achieve broad diversification and asset allocation where investors can get broader exposure with reduced risks compared to investing directly in securities. A fund of funds also referred to as a multi-manager investment, gives small investors broad diversification to hopefully protect their investments from severe losses caused by uncontrollable factors such as inflation and counterparty default.

Fund of funds investors typically pays higher fees than investors in traditional investment funds. The fee comprises the fees of the underlying funds and the professional management fees charged by the FOFs. After paying all the management fees and taxes on the investment, investors in FOFs may earn lower net returns than if they had invested in a single regular mutual fund.

Short-term capital gain tax according to the income tax slab of the investor would be applicable if sold before 36 months. If the units are sold after 36 months, a long-term capital gain tax of 20% with indexation is levied.

Although diversification is considered a favorable strategy for reducing risk exposure, it may not result in optimal gains because the process of selecting funds managed by a large pool of fund managers is a difficult task. Investments aimed at broad diversification tend to underperform during times when only one or two market sectors or asset classes are performing well.

The success of FOFs depends on the ability of the fund manager to choose funds that produce a high rate of return on investment. The fund manager receives compensation as a percentage of the assets under management and as a percentage of profits. Depending on the number of performance fees that a manager gets, he may take higher risks with the aim of making higher returns for himself and the fund’s investors. If the manager is an active trader, he may make frequent transactions to profit from temporary price fluctuations.