FUND FLAVOUR

February 2014

 

Fund of Funds - A smart way of investing in mutual funds

Fund of Funds (FoFs) offer investors a unique and excellent investment proposition. These are meta-funds, mutual fund schemes that invest in the schemes of other mutual funds. They take the concept of mutual fund investing to the next level. While mutual funds invest in stocks of various companies, FoFs invest in the schemes of their own fund house or a third party fund house, a smart way of investing in mutual funds. 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, while when you buy a fund of funds, you hold just one fund which in turn holds other mutual funds inside it.

Fund of Funds stand out

 

How does it benefit investors, you may ask? Well, the benefits of a FoF are numerous. You can obtain combinations of the best performing funds of different fund houses. FOFs are designed to provide greater diversification than regular mutual fund schemes. Diversification helps reduction in volatility while maintaining average returns. FOFs fund manager takes care of the research and process required to select the right fund in the portfolio. FoFs allow you to diversify risk by stage and size of investment and industry sector by investing across a wide spectrum of leading funds. A lay investor will 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. With multiple fund managers and schemes in the underlying portfolio, FOFs helps reduce the impact of bad performance by any of the fund manager or the fund. More importantly, mutual fund schemes are exempt from taxes on their capital gains. This would make a FoF a very tax-friendly instrument whenever the portfolio is re-adjusted between equity and debt. As compared to this, you have to pay capital gains tax when you redeem profits from the funds. By investing in FoFs, you do not need the services of a financial advisor whose advice could at times be biased, unsuitable, and expensive.

 

Fund of Funds have their downside too

 

For the funds, the downside is that expense fees for FoFs are higher than that in the case of ordinary schemes since management fees have to be paid twice. Their cost structure will include the fees already charged by the funds in which the investments are made. Another flipside is that since the FoFs invest in a whole host of schemes which are themselves invested in a wide range of stocks it is possible and sometimes inevitable that it will be investing in the same stock through the different schemes. In terms of taxation, a FOF enjoys the status of debt mutual funds even if it invests 100% of its corpus in equity mutual funds.

 

Fund of Funds on a roller coaster ride

 

Fund of Funds have grown manifold in the last decade. They have shown phenomenal increase from a mere three funds in 2003 to 39 in 2012. Not only in terms of numbers, but also in terms of assets under management, the growth has been tremendous. The assets under management have increased from Rs 645 crore in 2003 to a high of Rs 6741 crore in 2012. During 2013 there have been no new FoFs. There has been a 20% slide in the AUM of FoFs during the past one year. In addition to the drought in FOFs in the NFO market, redemptions have been rife. With the Sensex scaling new heights, investors tried to capitalize on the gains. The previous dip was in 2008, which can be attributed to the global financial crisis.

Fund of Funds still a non-starter?

 

Fund of Funds by their very design are meant to lose less. Still, only 1% of the Indian mutual fund industry's AUMs are made up of FoFs. Because it holds many funds in it, FoFs will not deliver performance equal to or better than the single best performing fund that it has invested in. The return of 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. Secondly, FoF, 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 how will a distributor add value to the investor. This misplaced perception has begun changing in the recent past. Thirdly, the larger share of FoFs 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.

The bottom line

FOFs can be a pain-free entrance into the harsh mutual fund world for investors with limited funds, or for those who have limited experience with mutual funds, but this does not mean every FOF will be the perfect fit. You should read the fund's marketing and related materials prior to investing so that the level of risk involved in the fund's investment strategies is understood. The risks taken should be commensurate with your personal investing goals, time horizons, and risk tolerance. As is true with any investment, the higher the potential returns, the higher the risks. If you do not have the time and/ or the inclination to select STOCKS - Invest in MUTUAL FUNDS. If you do not have the time and/ or the inclination to select MUTUAL FUNDS - Invest in FoFs.