Monday, December 18, 2006

Curtains down on Classification --Specialty Funds …(contd.)

Curtains down on Classification

Specialty Funds …(contd.)

A "Fund of Fund" (FoF) is a mutual fund scheme that uses an investment strategy of holding a portfolio of other mutual funds rather than investing directly in shares or bonds or other securities. This type of investing is often referred to as Multi-manager Investments. A Fettered FoF limits the fund selection to only include the range of funds they manage whereas Unfettered FoF includes funds from various AMCs.

In India, FoFs were initially offered by three funds- Franklin Templeton’s FT India Dynamic PE Ratio Fund of Funds, Birla SunLife’s Birla Asset Allocation Fund and Prudential ICICI Mutual Fund’s Prudential ICICI Advisor Series Plans. Now, there are more than a dozen FoFs.

“Does it make sense to invest in FoFs? “


Double Diversification - A Fund of Fund diversifies across many different funds (which in turn diversify across securities). Thus there is diversification across asset classes and investment styles.

Simplicity - FoFs have access to the portfolio of various top-performing funds with just one investment. This allows for much less paperwork and easy monitoring.

Cheap for Beginning Investors -It is tough to diversify when starting out because of account minimums. Suppose you wanted to invest in 5 equity funds and 5 debt funds, assuming each fund has a minimum stipulated investment of Rs 5,000, you would need Rs 50,000. In a FoF, Rs 5,000 would suffice.

Institutional Advantages -Funds of funds can often invest in desirable institutional funds that are outside the purview of retail investors.They also have the ability to invest in some load funds without paying the load.

An investment manager may actively manage your investment with a view to selecting the best securities. A FoF manager will select the best performing funds to invest in based upon the managers’ performance. This additional level of selection can provide greater stability and take on some of the risk relating to the decisions of a single manager.

The in-built rebalancing feature ensures that market movements do not change the desired asset allocation. The fund composition can be altered in no time in FoFs whereas this process may take a long time to complete in a Balanced Fund since its constituents are instruments instead of funds. It is the difference between having 10 individual roses and a bouquet of 10 roses.The second benefit that FoF rebalancing offers is a psychological one. Usually people don't sell when the markets are rising and don't buy when the markets are falling. Yet this is exactly what one should be doing. FoF does it automatically (and it usually can be in your long term interest).


Double diversification may at times introduce duplication as it is possible for the FoFs to own the same stock through several different funds and it can be difficult to keep track of the overall holdings. Investor may have to monitor whether the fund manager is sticking to the stated asset allocation. Investors should also be careful about the timing of their entry into the scheme.

As per the present tax laws, equity FoF does not enjoy the benefits available to a normal equity fund. Therefore, if one invested in an equity FoF he would be liable to pay dividend distribution tax of 14.03% or LTCG tax of 10% (without indexation), which is otherwise NIL for a normal equity MF. This higher tax can significantly reduce the post-tax returns.

Fund of Funds = Cost of costs

Investors should also be aware that cost heads like fund management fee and other expenses in each of the scheme, where FoF would be investing, reduce returns. The additional expense that an investor can incur is a maximum of 0.75 per cent that FoF is permitted to charge for meeting its expenses such as audit fees, statutory disclosures, etc. Thus the effective cost works out to around 3.25% and 2.25% for equity & debt MF respectively (the annual management fees are typically 2.5% for an equity MF and 1.5% for a debt MF).

The convenience that an FoF offers should more than make up for this marginally extra cost. Moreover, the entry load is taken at fund level. When the fund invests in underlying schemes, the load factor is waived off if the schemes are chosen from the same fund house.

The onus is on the investors to assess their profile in the light of these factors and then take a decision as to whether a FoF fits into their portfolio or not.

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