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Funds of funds are a category of mutual funds which invest in mutual funds that further invest in assets like shares, gold, silver and bonds. They do not directly invest in commodities like gold, silver, or shares, but rather in equity, debt, silver or gold funds. Some FoFs also invest in overseas or international funds.

FoFs come under other categories of mutual funds. FoFs invest a minimum of 95% of its total assets in an underlying fund, which further invests in equity, debt, silver, gold or international stocks.

Now, let’s see how these funds have fared in terms of returns. Every category under this fund offers different returns. Based on data as on 11th October, 2023, debt oriented FoFs have delivered average returns of 7% over the past year, 5% over three years and 7% over a 5-year period. On the other hand, equity oriented FoFs have generated comparatively higher returns. They have delivered 19% returns during the past year, 23% over the past 3 years and 14% over a 5-year period.

Now, the question is, should the investor put their money in such funds?

For investors who are looking for high quality and returns with less risk, FoFs are a good option. These funds are ideal for those investors who do not want to spend time over constructing their portfolio and want to leave all the hard work to the FoFs fund manager.

But before investing in these funds, it is important to understand how these funds work, taxed and their other distinct characteristics.

Deepal Gagrani, founder of Madhuban Finvest, says that it is important to understand about all about the high total expense ratio (TER) and the possibility of funds overlapping amongst each other in such FoFs, which can diminish the overall benefits offered by fund diversification.

Also note that FoFs is considered a debt mutual fund for taxation purposes. This means that irrespective of the FoFs investment in any asset, the fund will be taxed like a debt fund, and not like an equity oriented fund.

So, if you redeem your FoFs units within a year, a 15% tax will be levied on your returns. If you also rake in more than Rs 1,00,000 as capital gains within a financial year, you will have to pay long-term capital gains tax at the rate of 10%

FoFs which focus on liquid, index or ETF schemes can charge a maximum of 1% of the schemes NAV as total expense. On the other hand, for FoFs which invest majorly in actively managed equity schemes, the total expense ratio cannot exceed 2.25%, which is considered high.

Investors should assess an FoF based on the fund’s expenditure and the performance of underlying funds the FoF is investing in. Investors should carefully evaluate all pros and cons of such a fund, and then invest only according to their risk profile and financial objectives.