FUND FLAVOUR

February 2016

The flexible fund manager

Fund of funds (FOF) invest in other mutual funds that hold promise and regularly rebalance their portfolios if the performance of one or more funds they have invested in is lacklustre. For investors, it allows an entry into many different funds with a small investment. And it also does away with the need to keep tabs on your asset allocation. In a nutshell, they offer off-the-shelf asset allocation. A readymade asset allocation solution, compared to investing directly in a varying portfolio of shares, bonds, and mutual funds saves time.

Pros and…

Simplified investing: If you are a first-time investor, choosing the right mutual fund can be a tough decision. There is no way to ensure that your funds will outperform. Opting for the best performing fund is not always a solution. A fund may do very well one year but slip the next year. Last year's laggards can be this year's winners. The FoF takes care of this problem by making the decision for you. You do not have to analyse individual schemes and find which ones suit your needs and goals. You also need not track the performance of the schemes in your portfolio. If the fund manager thinks a certain scheme has not been doing well, he will exit from the fund.

Multiple diversification: FoFs take diversification to a new level. FoFs reduce the risk for the investor by spreading the corpus across several different schemes. This gives a multi-cap flavour to the FoF. For instance, an equity FoF may have a mix of small-cap, mid-cap, and large-cap oriented funds in its portfolio, thus providing enough diversification. In fact, some feel that a well-chosen FoF can be your one-stop shop for equities. Investors can meet their diversification needs merely by holding one such scheme. The FoF makes sure that the risk gets spread across different types of equity schemes, thus offering better risk-adjusted returns. Keep in mind that some FoFs pick funds from across the spectrum, while others restrict themselves to the schemes from their own fund house. From the diversification point of view, the schemes that pick from different funds appear a better bet than those with a restrictive mandate. The ING Optimix Five Star Multi Manager FoF invests in five equity diversified funds from four fund houses as well as a Nifty ETF.

Convenience: The investors who put their money in a FoF do not need to monitor the performance of different schemes constantly. It also saves them from churning their portfolios, that is, frequently moving from equity to debt schemes, or vice versa, depending on the market outlook. The fund manager of a FoF will take care of the churning that is necessary.

Affordability: 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 a FoF, you can invest in 10 such funds with just Rs 5,000.

Despite the advantages they offer in asset allocation, this category has not yet caught on with the average investor. All FoFs have a total corpus of about Rs 7396 crore, with Rs 5373 crore invested in domestic FoFs and Rs 2023 crore in overseas FoFs. This is minuscule compared to the close to Rs 13 lakh crore of assets under management in the entire mutual fund universe. There is hardly any awareness about fund of funds and their advantages. This is like a fill-it-shut-it-forget-it investment vehicle, as the asset allocation is done by FoF service provider at no ‘extra’ tax impact or load on investors.

…Cons of FoFs

Additional layer of costs: The convenience and benefits of an FoF come at a cost. The investor pays a higher fund management fee than that for an equity fund.  Investors are effectively burdened with two layers of costs—fund management fee charged by the fund (around 0.75% a year) as well as the expenses of the underlying schemes in its portfolio (another 1.5-2% per year). For the investor, the total cost can add up to nearly 3% per year. This does not hurt when the market is giving a return of 20-25%, but if the market is going to rise by barely 10-12% and the expense ratio shaves off 3% off your return, you cannot ignore this aspect.

Duplication: Besides, there is a likelihood of duplication in the holdings of the funds in the portfolio. The mother fund could be investing in the same stocks through its underlying schemes since there is a high degree of overlap in the portfolios of the top equity schemes. You may be paying the fund manager for investing in the same stocks through four to five different schemes.

Tax treatment: One important shortcoming in the case of FoFs is that they do not get the generous tax treatment meted out to equity-oriented funds. The taxman regards them as debt funds even if they hold equity-oriented funds in their portfolio. Short-term capital gains (earned by selling the fund within one year) are added to the income of the investor and taxed at normal rates. So, if your taxable income is more than Rs 8 lakh a year, you would have to shell out Rs 300 as tax for every Rs 1,000 earned from the scheme (instead of Rs 150 in a regular fund). The long-term capital gains (sold after a year) from ordinary equity-oriented funds are tax-free. However, long-term gains from FoFs are taxed. There are a few tax benefits too. When an investor switches between individual schemes within one year of investing, he is liable to pay capital gains as well as exit load. However, in case of switching or rebalancing by the fund manager of a FoF, there is neither any tax implication nor any exit load.

The Central Board of Direct Taxes (CBDT) has exempted Alternative Investment Funds (AIFs) from the obligation to deduct tax at source  (TDS) at a rate of 10% from distributions made to fund of funds (FoFs) registered as AIFs. Obligation to deduct TDS at a rate of 10% continues to apply to income distributed by FoFs to their underlying investors. FoFs are permitted to register as AIFs under SEBI (Alternative Investment Funds) Regulations 2012 (AIF Regulations). FoFs registered as Category I AIFs are permitted to invest in other Category I AIFs of the same sub-category. FoFs registered as Category II AIFs are permitted to invest in other Category I AIFs and Category II AIFs.

Multi-manager Funds gradually gaining ground in India

Tata Mutual Fund recently launched several new equity funds under an umbrella theme—'Own a piece of India'. It is a basket of six thematic and sector-oriented funds (including an existing one) through which investors can participate in India's growth story. The scheme follows a multi-manager approach with a lead manager at the helm, supported by co-managers. The multi-manager approach taps the expertise of multiple individuals. Investors benefit from the combined experience of several people, minimising the dependence on a single money manager. A true multi-manager approach is one which provides exposure to different investment styles apart from asset classes. Otherwise, it is nothing more than just a hybrid fund. While the 'Own a piece of India' scheme offers exposure to different sectors or themes like Digital India, consumption, pharma and healthcare, banking and financial services, energy and infrastructure, the same can be achieved with a good diversified equity fund.

There are enough funds with proven track records which offer investors similar broad-based participation in the India growth story, at a lesser cost. Unlike other multi-manager schemes, Tata MF's offering allows investors to pick and choose from the available schemes in its basket. However, this customisation is good only if you have enough understanding of sector dynamics to take a call. Also, unlike others in this category, investors may incur tax and exit load in case they switch between schemes in the fund basket. The good part is that it will allow investors to exit any of the underlying funds if it is underperforming. Since the underlying schemes are within the same fund house, the benefit of investing across fund managers is diluted to some extent. A true multi-manager approach can be best tapped through a zero brand-bias offering. Even then, the ideal approach is to create your own portfolio of traditional funds by picking from the best-of-breed funds across different AMCs with the help of an adviser.

On your marks

When investing in a fund of funds, watch out for these factors.

·         Enter when the markets are down. It gives an opportunity to accumulate units at a lower cost

·         A flexible fund of funds will invest in debt and equity with an open mandate to switch between the two

·         They may react slowly to market conditions; hence, look for funds with dynamic asset allocation

·         Some funds have an in-built trigger mechanism based on pre-designated parameters such as PEs, asset allocation, or momentum. It helps discipline asset allocation

Look for funds that have an in-built asset allocation model, which performs better in a down market than a FoF that only invests in other equity funds. Investors must also keep an eye out for the type of assets an FOF invests in.

Some more filters

Before you embark on a FoF investment strategy, there are a few factors that you must consider. You may want a dynamic fund of fund that can take advantage of all types of market conditions. Funds with a flexible equity and debt mix may be your answer as the asset allocation reflect the regularly changing market conditions.

Assess the past performance, and whether the fund has kept up with its benchmarks. Also, check whether the FoF invests in funds across the industry or only in funds from its own fund house. The corpus size is a good indicator of its popularity. Also, watch for asset allocation models. For instance, Franklin Templeton’s P-E ratio FOFs essentially invest only in two of its own funds—the Blue Chip and the Templeton India Income Fund. But the asset allocation between the two depends on the Nifty’s index valuation. As the index valuation goes up, more funds are allocated to its income fund. ING Optimix’s Asset Allocator Multi Manager FOF scheme can move from 100 per cent equity to 100 per cent debt and vice versa. After all, in today’s topsy-turvy market, an investor needs all the flexibility he can get.