FUND FLAVOUR

February 2012

Of FoFs and Multi-manager investing …

A mutual fund that invests in other funds is a fund of funds (FoFs). Conceptually it does what you do, create a portfolio of funds. The difference being, when you buy funds yourself, you buy them individually and hold and track them separately, whereas when you buy a fund of funds, you hold just one fund which in turn holds other mutual funds inside it. This type of investment is also known as multi-manager investment. An FoF can be defined as either an asset allocation FoF or a single asset class FoF. The former invests in both equity and debt schemes, while the latter does so in one of these. An equity FoF will invest in only equity schemes; a debt FoF will touch only debt schemes; a equity-plus-debt FoF will have a mix of equity and debt schemes in its portfolio and a multi-asset FoF will invest in the units of one or more gold ETFs in its portfolio in addition to equity and debt schemes. The investment pattern and style of FoFs vary for different asset management companies (AMCs). Some FoFs invest in other schemes of the same AMC, whereas others do so in mutual fund schemes floated by other fund houses.

Fledgling Indian FoF Market …

When markets are in a bearish phase, the one who loses less is called a winner. Fund of Funds, by their very design, are meant to lose less. Inspite of this, only 1% of the Indian mutual fund industry's Assets Under Management is made up of Fund of Funds. There are valid reasons for this state of affairs.

A fund of funds will not deliver performance equal to or better than the single best performing fund that it has invested in because it holds many funds in it. The return of a fund of funds will always be closer to the weighted average returns of the funds it has invested in, quite like the return of your own portfolio of funds. And by the very same logic, a FoF will not go down as much as the worst performing fund it holds inside it. For this very reason, fund of funds are known to give superior risk adjusted returns.

FoFs, until very recently, were perceived as competition by distributors. If one single FoF itself can buy, hold, sell, over-weight, under-weight the funds it invests in, then there is no question of a distributor adding value to the investor. This misplaced perception has begun changing in the last one year.

Majority of fund of funds currently available in India actually invest in funds of only their own fund house. This limits the diversification benefits an investor aims for when he himself buys mutual funds from different fund houses. Globally, several fund of funds pick the best funds from across different fund houses and put them together into one. These are called Multi Manager fund of funds. It is like putting together the best cricket players from across the world into one team. 

Investors have to bear the recurring expenses of the FoF scheme in addition to the expenses of the underlying schemes. In view of the double layering of costs, the expense ratio of an FoF is higher than that of the other funds. 

There is a danger of duplication in FoFs. Since fund of funds buy many different funds which themselves invest in many different stocks, it is possible for the fund of funds to own the same stock through several different funds and it can be difficult to keep track of the overall holdings.

Advantages of FoFs far outweigh the disadvantages

In a nutshell, for a first time investor, FoF is a great way to start investing in mutual funds. You need not worry about how to pick, retain or change a fund. If you are a SIP investor, just a SIP of Rs 1,000 could actually give you access to 4-5 best managers in one fund of funds as against you having to shell out Rs 1,000 minimum subscription for every manager you will invest in separately by yourself.

For those who already hold too many funds and see managing them a hassle, fund of funds aid simplification and consolidation of their holdings, as long as they can find one that is similar in objectives to the funds they hold. And the good news is that options do exist. The investors who put their money in FoFs do not need to monitor the performance of different schemes constantly. It is convenient and saves them from churning their portfolios, i.e., frequently moving from equity to debt schemes, or vice versa, depending on the market outlook.

FoFs often invest in sought-after institutional funds that are beyond the reach of retail investors. This also makes investing affordable for the investors. So, if you want to invest in five equity funds and five debt funds, and the minimum investment requirement for each fund is Rs 5,000, you will need Rs 50,000 to invest in these schemes. On the other hand, in the case of an FoF, you can invest in 10 such funds with just Rs 5,000.

When an economy is experiencing a slowdown, following a fixed investment style can be detrimental to the fund's performance. For example, mid-cap funds may underperform as mid-cap stocks are usually hammered during a downturn, or a sectoral fund may give low returns because some sectors suffer due to macro-economic factors like rising interest rates or reduced consumer spending. In such a scenario, diversifying across investment styles or multiple investment portfolios can prove beneficial. This is the basic premise of a category of mutual funds known as fund of funds, or FoFs. An FoF invests in schemes of other mutual funds and aims at diversification by spreading risk across a larger universe.

Amongst the least known but significant advantages of a fund of funds is the short-term capital gains tax that you can save. If we assume that you do change some if not all the funds you hold at least once within the first 12 months of investing in them, the gains you make on them become taxable. However, when a fund of funds manager changes any fund it has invested in, there is no tax liability that accrues to you.

Now if you combine all the above benefits, it becomes easier to appreciate the rapid growth of FoFs in India recently. FoFs are now available here for single asset classes and for multiple asset classes too. Globally, fund of funds are often preferred by super HNIs for just two reasons - their superior risk adjusted returns and equally important, their convenience.

… to mature market?

There are about 40 FoF schemes in existence today being offered by the same mutual funds that offer you equity, debt and other schemes with AUM of Rs 6741 crore as on December 31, 2012. 5 Equity FoFs have returned an average of 15.3%, 18 Hybrid FoFs have earned 11.7%, 4 Debt FoFs 9.4%, and 10 Commodity FoFs 4.8% in the past one year.

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Ideal FoFs…

Choosing the right FoF is made relatively easy due to its small universe. Equity investors can go for equity FoFs, debt investors can choose debt FoFs, gold lovers can go in for Gold FoFs and there is even an FoF that invests in all the three asset classes of equities, debt and gold through exposure in units of equity, debt, and gold ETF schemes. An important element to keep in mind before deciding on a FoF of a mutual fund is whether its investments will be restricted to the schemes of the same mutual fund or whether it will invest in multiple mutual funds’ schemes. The ideal FoF is one that invests across the schemes of multiple mutual funds. Investors should avoid a single mutual fund-focused FoF scheme.

As far as their performance is concerned, most of the equity oriented FoFs led by the domestic equity oriented ones have delivered luring returns across time frames and have also managed their risk well (as revealed by their Standard Deviation) which has resulted in them providing appealing risk-adjusted returns (as revealed by their Sharpe Ratio). However while investing in them, you should not just get lured by the past performance they have delivered, but also delve a litter deeper to ascertain aspects like investment objective and asset allocation as mandated for investment, track record of the underlying mutual fund schemes in its portfolio, portfolio of stocks and sectors which the underlying funds have an exposure to, investment processes and systems followed by the fund manager while choosing the underlying funds. In addition, you need to assess the tax implication of investing in a FoF scheme, as this would have an impact on the post-tax returns, which you earn on your investments.

 …for your portfolio

But before you invest in a FoF, you need to check whether the investment objectives and the asset allocation followed, suit your investment objectives as well. Moreover, you need to be ready to bear the high net expense fee of a FoF. An FoF is a worthwhile investment proposition for new and small investors willing to build a portfolio of quality mutual funds but lack resource of researching and choosing the right funds and for investors who want to eliminate the cost incurred on research and advise on investment in regular mutual funds and the hassle of maintaining and tracking their investment in multiple schemes.