There are 669 mutual fund schemes in the market spread across 24 categories. Does that leave you a little bewildered about where you should park your hard-earned money'
Sure, it's a problem of plenty and a vast array of confusing choices. But worry no more: help is at hand. It's called fund of funds (FoF). The FoFs have some distinct advantages over regular mutual funds that suit the risk profile of small investors and their shallow pockets. In fact, the FoFs are particularly beneficial for those who want to jump on to the stock market bandwagon for the first time.
A fund of funds is exactly what it sounds like: it is a mutual fund that invests in the units of other mutual funds, while a regular mutual fund invests in shares, bonds and other fixed income securities in accordance with its objective.
This may sound silly at first. But there are some unmatched benefits in investing in FoFs.
Consider this: if you buy a regular diversified equity fund, the performance of your investment will largely depend on the expertise of the fund manager concerned. The fact that the market perception, outlook and the investment prudence of different fund managers vary significantly is reflected in the large variations in returns across different mutual funds.
But, an investor in a fund of funds is benefited by the expertise of several fund managers, diverse fund management styles and strategies.
However, the biggest advantage of a FoF comes from double diversification of portfolio stocks. A regular mutual fund generally invests in the shares of 30-50 different companies. So, the unit holders of a mutual fund are exposed to only those stocks, and not more.
The fewer the number of stocks in the investment portfolio of a mutual fund, the greater the risk on the part of the unit holders to make a profit or suffer a loss. This risk diminishes with the diversification of portfolio.
But, it is tough to diversify when one starts to invest because of account minimums. A fund of funds allows an investor to diversify among hundreds or thousands of stocks in one small account.
In an FoF, which diversifies among various mutual funds, the investment portfolio automatically gets more diversified than each of its constituent mutual funds.
While the return from a FoF depends on the selection of the mutual funds, it rarely happens that it is widely divergent from those of the underlying funds.
But downward risk in an FoF gets drastically reduced following the double diversification ' first at each mutual fund level and then at the multi-mutual fund level.
The investor in an FoF also doesn't need to track the performances of various schemes, or churn one's portfolio as and when the market moves up or down.
However, first-time investors can take heart from the fact that they don't have to dig deep into their pockets if they choose to invest in an FoF, instead of a number of regular mutual funds. Fund of funds provides the investor an opportunity to be invested in all the schemes at a fraction of the original cost.
The flip side is that some FoFs charge a higher fee. And the expense ratio of most FoFs are also higher than regular mutual funds. These two costs may eat into the returns over a long period.