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Mutual funds operate in a fixed investment style, which is stated in their offer documents. In the case of equity funds, the style can be explained in terms of the types of stocks (large, mid or small cap, value stocks, or growth stocks), or sectors (such as infrastructure, auto, banking). For debt funds, it depends on the quality and type of debt paper, such as AAA or government bonds.

However, when an economy is experiencing a slowdown, following a fixed investment style can be detrimental to the fund's performance. For example, mid-cap funds may underperform as mid-cap stocks are usually hammered during a downturn, or a sectoral fund may give low returns because some sectors suffer due to macro-economic factors like rising interest rates or reduced consumer spending.

In such a scenario, diversifying across investment styles or multiple investment portfolios can prove beneficial. This is the basic premise of a category of mutual funds known as fund of funds, or FoFs. An FoF invests in schemes of other mutual funds and aims at diversification by spreading risk across a larger universe. Here are some of its features.

Types:

An FoF can be defined as either an asset allocation FoF or a single asset class FoF. The former invests in both equity and debt schemes, while the latter does so in one of these. The investment pattern and style of an FoF varies for different asset management companies (AMCs). Some FoFs invest in other schemes of the same AMC, whereas others do so in mutual fund schemes floated by other fund houses.

Multiple diversification:

FoFs take diversification to a new level. As these invest in more than one mutual fund scheme, it broadens the investment portfolio. For example, an FoF can invest in the five best performing funds and offer the maximum diversification. The risk level associated with wide portfolios is significantly lower than that for an individual fund portfolio.

Convenience:

The investors who put their money in an FoF do not need to monitor the performance of different schemes constantly. It also saves them from churning their portfolios, that is, frequently moving from equity to debt schemes, or vice versa, depending on the market outlook. The fund manager of an FoF will take care of the churning that is necessary.

Affordability:

FoFs often invest in sought-after institutional funds that are beyond the reach of retail investors. This also makes investing affordable for the investors. So, if you want to invest in five equity funds and five debt funds, and the minimum investment requirement for each fund is Rs 5,000, you will need Rs 50,000 to invest in these schemes. On the other hand, in the case of an FoF, you can invest in 10 such funds with just Rs 5,000.

Expenses:

A major drawback of an FoF is its higher expense compared with other equity funds. This is because the investors have to bear the recurring expenses of the scheme in addition to the expenses of the underlying schemes. There is a double layering of costs, so the expense ratio of an FoF is higher than that of the other funds.

Tax treatment:

Another disadvantage is the tax treatment of FoFs. Despite being equity-oriented funds, FoFs are considered debt funds and are liable to dividend distribution tax, as well as the long-term capital gains tax.