Markets have been buzzing with activity ever since the launch of fund of funds (FoF) was announced by some asset management companies. The fact that this launch coincides with a very exciting time in the equity markets only adds to the hype. Let's try to understand what a fund of funds is and what it means to the retail investor in the Indian context.

A regular mutual fund invests in stocks, bonds and fixed income securities depending on its objective. Hence the investor gets an opportunity to participate in these market-linked instruments while utilizing the fund manager's expertise.

Fund of funds further extends this concept wherein a mutual fund invests in units of other mutual fund schemes. So what is motive behind having a FoF? The answer is – "Diversification".

Fund of funds takes diversification to a new level. By investing in more than one mutual fund, the fund ensures that the investors holding are diversified across the widest possible range.

For example a FoF can invest in five of the top performing equity funds and offer the most widely diversified portfolio to the investor. Similarly a FoF could invest in equity funds and income schemes simultaneously offering the investor a "diversified-across asset class" portfolio. The risk levels associated with such holdings are theoretically even lower than those of conventional mutual fund schemes.

Another notable advantage enjoyed by FoF investors is diverse management styles. If a FoF were to invest in top performing funds, the investors would benefit from the expertise of more than one leading fund manager. With each fund manager comes his unique style and strategies.

The cost of investing can reduce significantly for an investor. Instead of investing say Rs 2,000 each in 5 schemes i.e. Rs 10,000 totally; the investor can invest the desired amount in one scheme. Fund of funds provides the investor an opportunity to be invested in all the schemes at a fraction of the original cost.

Convenience is another area where fund of funds score heavily. The investor is spared the bother of tracking the performances of various schemes. Also he doesn't have to churn his portfolio. E.g. if the equity markets hit a rough patch while the debt markets start looking up, the investor won't have to reduce his holding in equity funds and invest in debt schemes. The fund manager from his FoF will do the needful. The fact that his portfolio is not tampered with implies that the incidence of tax (capital gains) is avoided.

However, the moot question to be addressed is will it make sense for retail investors to invest in a fund of funds in the present scenario? Recent times have seen mutual fund schemes offer record performances. Nearly a dozen equity schemes have offered returns of over 100% in the past 1-year. By opting for a FoF over a mutual fund (which in any case offers a fair degree of diversification) the investor may lose out on a good investment opportunity.

Fund of funds is an alien and hitherto untested concept for retail investors. At best it can be regarded as 'imported' concept whose feasibility in local conditions remains to be seen.

For instance, index funds had made their debut in the country with much fanfare, but did not find much favour with investors as actively managed funds continued to outperform benchmark indices. Index funds clicked in markets like the United States, where active funds have not had it as easy. It makes one wonder whether fund of funds is also not a concept that is ahead of its time.