Retail investors flock to Fund of Funds schemes for tax breaks and diversification

Mumbai: Retail investors are piling into fund of funds (FoF) schemes, lured by tax breaks, built-in diversification and the ease of tapping multiple fund managers through a single product. Data showed inflows of ₹28,067 crore in just the first five months of this financial year-nearly three times what came in during the whole of 2024-25.

Investor interest in this category picked up after the budget, which stipulated that investors holding these schemes for over two years would be subject to a long-term capital gains tax (LTCG) of 12.5%, instead of being taxed at their income slab rate.

"These work well for investors who want tax efficiency, cannot decide on which scheme to buy, or when to enter and exit," says Madhu Nair, chief executive officer, Union Mutual Fund.

Unlike a normal scheme that holds underlying stocks, bonds or commodities like gold or silver as per its mandate, a FoF is a strategy of holding a mix of mutual fund schemes.

"This diversification eliminates the need to constantly chase different fund managers, allowing investors to benefit from a broad range of investment approaches and expertise," says Kunal Valia, founder, Statlane - a Sebi-registered Research Analyst.

Distributors point out that a very common problem among investors wanting to move from a mid-cap or a small-cap scheme to a large-cap is the tax outgo on account of capital gains, which leaves them with less money to invest. However, in a FoF structure, the fund manager can move from one scheme to another or alter allocation to schemes without tax implications for the investors.

There are pure equity FoFs, thematic FoFs that invest in a mix of domestic equity fund schemes/themes or domestic ETFs. While some fund houses stick to their own schemes, a few also invest in schemes of different fund houses, thereby helping investors diversify fund house risk.

Besides equity FoFs, there are asset allocator FoFs that invest in a mix of equity, fixed income, and commodities like gold and silver, with the allocation to each asset decided on the basis of the fund house's market view. There are also debt FoFs, such as the income plus arbitrage FoF, which cater to investors in fixed income and arbitrage.

While FoFs offer flexibility, they come at a cost. Though FoFs invest in direct plans of the target mutual fund schemes, there is an additional layer of expense for the investor, leading to higher costs, than plain vanilla equity schemes.