A number of fund houses in the country are ready to launch their fund of funds product. Is it better for an investor to invest in a plain vanilla scheme of a fund house or is a fund of funds better?

Okay, so what is a Fund of Funds (FoF) exactly? It is a mutual fund which invests in other mutual funds. Let us amplify this - a fund which invests in the schemes of other mutual funds.

So a FoF will hold units of several other schemes in the same manner as a scheme holding shares of different companies.

Why do we need a fund of funds?

Hedging, is a good answer. Investing in a fund of funds means greater diversification for the investor concerned - since he is hedging his risks across the sector. It works on the same principle as diversifying investments across a basket of securities.

Further, just a investing in a mutual fund scheme saves the investor the trouble of investing in the shares of so many companies and keeping track of them, investing in a fund of funds also saves the investor the bother of keeping track of all the schemes in the market as the fund manager does it for him.

All the investor has to so is to select his general risk profile - since fund of funds also need to be categorised according to the type of schemes they are investing in.

For instance an FoF can invest in other sector specific schemes - and as in the case of shares they can enter and exit schemes depending upon which sector they want to be weighted in at a particular point of time.

Let us talk about some of the benefits of a fund of funds. One point we have already touched on is diversification which leads to risk mitigation.

FoFs allow investors to diversify risk by stage and size of investment and industry sector by investing across a wide spectrum of leading funds.

Fund selection is important and we assume that most funds would invest only in the top performing schemes. A lay investor would not always be able to distinguish a scheme which is an excellent performer and one which is mediocre.

It stands to reason that an experienced fund manager is in a better position to make superior fund selection decisions. FoFs also provide access to top-tier fund investments which are often inaccessible to small or new investors.

Fund of Funds also remove the requirement for a dedicated in-house team which would be expensive to recruit and retain. It allows the outsourcing tasks such as investment screening, due diligence, negotiation and monitoring to specialists.

However one must not run away with the idea that fund of funds are the best thing to happen so far and the solution to all your problems.

For the funds the downside is that expense fees for such schemes are higher that in the case of ordinary schemes since management fees have to be paid twice - since their cost structure will include the fees already charged by the funds in which the investments are made.

For the investor the problem is how the FoF structures its cost based on its expenses and how much will be passed on to the investor. They have to pay the management fees twice.

Another flipside - since the fund of funds is investing in a whole host of schemes which are themselves invested in a wide range of stocks it is possible - sometimes inevitable - that it will be investing in the same stock through the different schemes.

In that keeping track of holdings, limits can be a problem. Of course, there will be regulations in place to check these nitty-gritty but still it is cumbersome.

In India, the Securities and Exchange Board of India has decreed that investments in the schemes which are under the same fund management should be restricted to five per cent of the asset of the fund.

Further in such a case no management fees should be charged for such investments.

The regulations have also put a ceiling on the expenses so this can probably take care of the final expense and the cost to the investor.

However according to industry circles it might be less expensive for an investor to invest in a fund of funds rather than a whole host of schemes individually.