Monday, February 04, 2008



Fund of Funds

Faux pas and mayhem!

  • Less than 10% of the fund managers have a ten-year record.

  • A paltry one fifth have a five-year record.

  • Half have spent a mere two years or less at the helm of their funds.

The odds are stacked against us. The fund management industry has risen to the occasion! It has faced these frightening facts with foresight by offering fund/manager research and selection in one product: a Fund of Fund (FoF) or a Multimanager Fund.

Funds as building blocks…

FoFs are mutual fund schemes that invest in other mutual fund schemes. An asset-allocation FoF invests in equity schemes and debt schemes and a single asset-class FoF invests predominantly in a single asset class, i.e. either equity schemes or debt schemes. The FoF offered in India generally are asset-allocation FoFs and thus tend to be hybrid in nature. Prominent players include Kotak Equity FoF, Fidelity liquid FoF etc. FT India Dynamic PE Ratio Fund of Funds was the first ever Fund of Funds launched in India in 2003 and it has grown at a CAGR of around 35%, which is decent by all standards. As the performance of the FoFs depends on the performance of the underlying scheme, in order to exploit its true potential, the fund manager has to be very astute while selecting the schemes across the fund houses. However, in India, fund houses have concentrated in investing in funds from their own stable, which has restricted their performance. Apart from Kotak Mutual Fund, ABN Amro and Fidelity, all other fund houses offering FoF schemes are investing in the schemes from their own AMC. An FoF that invests only in schemes from its own fund house is Closed Architecture, Single AMC FoF or Fettered FoF. Semi-Closed Architecture or Unfeterred FoF invests in other fund houses as well.

Managers as building blocks…

Multi manager funds cherry-pick the underlying fund managers in such a way that each brings a different style to the table that dovetail seamlessly into a complete portfolio. The fund is carved into small chunks with segregated mandates, tailored to their precise requirements, with each manager responsible for his/her own segment. OptiMix Financial Planning Multi Manager FoF Scheme by ING Vysya Mutual Fund is a multi manager Fund. OptiMix is a financial planning approach to funds. Fund management services are offered to financial planners, wherein they do the client interface and then pass on the funds to OptiMix to manage.

Are more minds better than one? Or do too many cooks spoil the broth? Those are the questions you need to ask when you consider whether to invest in a FOF or multi-manager mutual fund, which is one of the greatest ideas that has tread the path of the fund industry.

Fund of Funds have carved a prominent position on the pedestal with performance not hinged on a single fund manager and automatic periodic rebalancing with minimum monitoring.

Formidable Fortress…

The positive spin is that the FoF/multi-manager approach combines the top picks from some of the India’s leading funds/money managers with double diversification across asset classes and investment style.

FoFs provide a dose of stability to your holdings.

Convenience in investing and monitoring and affordability with a wide reach is the forte of FoFs and multimanager funds. 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 do the job.

Fund 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.

The movement of the fund managers from one fund to the other does not affect the performance of FoFs or multimanager funds since they are not at the mercy of a single fund manager but draw expertise from a smart pool.

Asset allocation accounts for 90% of portfolio performance. Portfolio rebalancing is one of the greatest benefits that FoFs and multimanager funds offer. Rebalancing involves capital gains tax, if you do it by holding individual mutual funds. When a FoF does it, there is no long/short term capital gains tax, which can be as high as 30% on short-term capital gains in a debt-fund. Moreover, you end up selling when the markets are rising and buying when the markets are falling, thanks to rebalancing. This psychological benefit transcends time and the ill-effects of market timing.

Patchwork portfolio, “cost of costs”and tax do raise their ugly head and disfigure the otherwise flawless sculpture…..

… or a Crumbling Citadel?

On the flip side, Feterred FoFs which invest in different funds of the same AMC are more prevalent and will not be truly diversified with duplication of holdings and style and unfeterred FoFs result in a patchwork portfolio that lacks any clear direction or investment philosophy.

The effective cost for you works out to around 3.25%(equity) and 2.25%(debt) for FoFs which charge an extra 0.75% as annual management fees over and above fees of 2.5 % and 1.5% for equity and debt funds respectively, as investors have to bear the recurring expenses of the scheme in addition to the expenses of underlying schemes. Thus there is a 'double layering' of costs. In addition, if there is going to be a churn in the portfolio, a certain percentage of returns will be lost due to the cost of re-balancing. True risk control requires highly skilled personnel who understand and can monitor FOF investment strategies, as well as the infrastructure to model risks and set boundaries for action. No small order. This can triple or quadruple the cost base of FoFs.

Your post-tax returns will take a beating if you invest in an equity FoF since you will be liable to pay dividend distribution tax of 14.03% or LTCG tax of 10% (without indexation), which is otherwise not applicable for a normal equity mutual fund.

FoFs under fire or in favour?

Globally, the concept is very popular with leading fund families such as Vanguard and Fidelity operating FoFs in the US but it has yet to gain due recognition in India. Will it take off in India? Yes, indeed, if you are keen on savouring the rich variety, enormity, economy, churn and convenience coupled with automatic rebalancing and market timing of this concept whose time has come.

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