FundsIndia explains: Fund of Funds

A mutual fund that invests in other equity, debt, gold or foreign mutual funds is a Fund of Fund(FOF). A FOF can invest in domestic mutual funds or in international funds. These funds could be investing in separate schemes in equity, debt or gold categories or in an asset allocated manner – that is a combination of equity, debt and sometimes gold. When they invest in a foreign fund, they become an international fund.

Popular fund of funds
Gold funds: Gold funds take the fund of fund route to investing in gold. They do so by investing in gold ETFs, typically from their own fund house. To invest directly in a gold ETF an investor would require a demat account. Gold funds facilitate investors to invest in gold without a demat. Furthermore in a gold Fund of fund, investors can do SIPs like they would with any other mutual fund. Some examples of gold Fund of funds are Axis Gold Fund, HDFC Gold fund, Kotak Gold fund and SBI Gold fund. They invest in their own gold ETFs.

Asset Allocation Funds: These funds seek to provide you with one fund that is diversified across different schemes from different asset classes. These can further be divided into two categories: dynamic funds that invests in equity and debt mutual funds based on the market valuation, measured by metrics such as the price to earnings ratio (P/E ratio) or price to book ratio or a combination such metrics. When the market metric such as the P/E ratio is high, the fund would reduce its exposure to its equity funds and instead increase in its debt fund holdings and vice versa. The fund and the fund manager will have stated internal metrics to decide the valuation band for such shifts. Franklin India Dynamic P/E Ratio FOF is a classic example of a fund which is dynamically managed based on valuations.

Rest of the asset allocation fund of funds invest in a combination of equity and debt are often labelled as being aggressive, moderate or conservative ; accordingly fixing the allocation between equity and debt funds. Then there are multi asset fund of funds that take a strategic as well as tactical allocation to various asset classes such as equity, debt, gold and cash.

While most fund of funds invest in their own schemes, there are multi-manager fund of funds that invest in schemes of other fund houses as well.

International fund of funds: Not all Indian mutual funds may have the resources and acumen to track international markets. Hence some of them choose to invest in an existing foreign fund, thus providing a route for Indian investors to invest in foreign equity funds. These funds allow you to invest in Indian rupees and you also redeem in your local currency.

These funds can invest in a specific country such as US, China or Europe or across countries (global fund). They can also invest in a specific theme such as commodities,agriculture or energy and so on.
While international funds provide exposure to foreign stocks for Indian investors, they carry dual risks. One is the market risk in that specific country or the theme risk. The other is the currency risk as your rupee will be subject to conversion volatility at the time of the fund deploying the money in such foreign markets.

Why fund of funds
Fund of funds suits investors to hold a basket of funds in one go – be it an asset allocated basket or one requiring to be dynamically managed in terms of asset allocation. This is convenient when with small sums, you can take exposure to multiple funds. Of course, there are advantages (discussed earlier)in gold funds and international funds as well.

However, on the flip side, fund of funds are treated as debt funds for tax purposes. That means despite taking equity exposure, they do not get the benefit of equity tax treatment. Also, most of these funds take exposure to their own fund house thus not providing you with different AMC styles or allowing you to choose the best in each AMC.