FUND FLAVOUR

February 2017

One of the many roads to asset allocation

Asset allocation funds are passively managed funds that help investors automatically buy low and sell high. They simply follow a formula-based process to determine the fund's bets on equity, debt, and money market instruments. This helps the fund to automatically “buy low and sell high.” If this appears to be quite a neat solution, such asset allocation funds have delivered widely differing returns to investors in recent times. The process that a fund uses to decide on asset allocation and the leeway they have to invest in equities, makes all the difference. The holy grail of good investing is maintaining a good asset allocation and FoFs do just that. Fund of Funds, that optimizes asset allocation, is one of the roads taken…

Fund of funds or multi-manager funds may sound interesting but do they deliver?

Fund of funds (FoF) or multi-manager funds, as they are known in developed markets, are funds which invest in other mutual funds. Simply put, instead of investing in stocks directly, a multi-manager fund will invest in the best schemes available in the industry. Thus, the performance of a fund of fund is directly linked to the performance of underlying mutual funds where the scheme has invested.

There are different types of FoFs in the market. For instance, some FoFs invest purely in equity funds while others diversify by investing in gold, equity and debt funds. The other category of FoFs invests in overseas funds which have exposure to international markets.

Why do we need a fund of funds?

Hedging, is a good answer. Investing in a fund of funds means greater diversification for the investor concerned - since he is hedging his risks across the sector. It works on the same principle as diversifying investments across a basket of securities.

Further, just a investing in a mutual fund scheme saves the investor the trouble of investing in the shares of so many companies and keeping track of them, investing in a fund of funds also saves the investor the bother of keeping track of all the schemes in the market as the fund manager does it for him.

All the investor has to do is to select his general risk profile - since fund of funds also need to be categorised according to the type of schemes they are investing in.

For instance an FoF can invest in other sector specific schemes - and as in the case of shares they can enter and exit schemes depending upon which sector they want to be weighted in at a particular point of time.

Let us talk about some of the benefits of a fund of funds. One point we have already touched upon is diversification which leads to risk mitigation.

FoFs allow investors to diversify risk by stage and size of investment and industry sector by investing across a wide spectrum of leading funds.

Fund selection is important and we assume that most funds would invest only in the top performing schemes. A lay investor would 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.

Fund of Funds also remove the requirement for a dedicated in-house team which would be expensive to recruit and retain. It allows the outsourcing tasks such as investment screening, due diligence, negotiation and monitoring to specialists.

Investors can track performance through one single window rather than accessing different accounts. Moreover, it takes away the pain of deciding in which fund to invest.

Investors do not have to fret about changing their asset allocation. The fund manager takes a call on the level of exposure to each asset class depending on the prevailing market condition.

However one must not run away with the idea that fund of funds are the best thing to happen so far and the solution to all your problems.

For the funds the downside is that expense fees for such schemes are higher than in the case of ordinary schemes since management fees have to be paid twice - since their cost structure will include the fees already charged by the funds in which the investments are made.

For the investor the problem is how the FoF structures its cost based on its expenses and how much will be passed on to the investor. They have to pay the management fees twice.

Another flipside - since the fund of funds is investing in a whole host of schemes which are themselves invested in a wide range of stocks it is possible - sometimes inevitable - that it will be investing in the same stock through the different schemes.

In that keeping track of holdings, limits can be a problem. Of course, there will be regulations in place to check these nitty-gritty but still it is cumbersome.

In India, the Securities and Exchange Board of India has decreed that investments in the schemes which are under the same fund management should be restricted to five per cent of the asset of the fund.

Further in such a case no management fees should be charged for such investments.

The regulations have also put a ceiling on the expenses so this can probably take care of the final expense and the cost to the investor.

However according to industry circles it might be less expensive for an investor to invest in a fund of funds rather than a whole host of schemes individually.

The TER (Total Expense Ratio) is on the higher side as investors are charged for both the underlying funds and the primary fund. FoFs are allowed to charge 0.75% over and above the expense ratio of the primary fund.

FoFs are taxed as debt funds. Investors do not get exemption on capital gains after a year. Instead, investors can avail indexation benefits after three years, wherein gains are taxed at 20% after adjusting for inflation during the tenure of the investment.

Theoretically, FoFs may sound interesting but that may not be necessarily true. This is because not all funds normally invest in schemes of other fund houses. While some funds invest in in-house schemes only, others invest in a mix of funds offered by other AMCs and in-house schemes. For instance, Birla Sun Life Financial Planning Fund FoF - Aggressive Plan invests in Kotak Gold Exchange Traded, Birla Sun Life Cash Plus, Mirae Asset India Opportunities Fund, and Birla Sun Life Frontline Equity Fund, among others. FoFs typically invest in direct plans of other schemes. Quantum Equity FoF is the only fund which invests in schemes of other fund houses. These funds are typically designed for passive investors.

Things to Consider Before Investing in Fund of Funds

Though FOFs provide diversification and less exposure to market volatility in exchange for average returns, these returns may be lessened by investment fees that are typically higher compared to traditional investment funds. These investment and management fees include all the fees charged by the portfolio's underlying funds. After allocating the money invested to fees and other payable taxes, the returns of fund of funds investments may generally be lower compared to the profits that single-manager funds can provide.

Fettered Management vs Unfettered Management

There are different kinds of FOFs, with each type acting on a different investment scheme. An FOF may be a mutual fund, a hedge fund, a private equity or an investment trust. An FOF may be fettered, which means that it only invests in portfolios containing assets and funds managed by one investment company. It may also be unfettered, which means that it invests in external funds controlled by other managers from other companies.

Fund of Funds stands out 

The plethora of schemes launched by all mutual funds makes the choice extremely tricky. The myriad schemes and plans/options make the investment decision even more difficult for investors. Hence, the chances of selecting the wrong funds also increases. This highlights that investors require expert advice for selecting good mutual fund schemes. And this is where FoFs comes to their rescue. Like a mutual fund manager specialises in selecting stocks, a FoF manager specialises in selecting the right mutual fund scheme for his fund. Hence, the decision of investing or redeeming a scheme lies with the fund manager. Hence what investors get at the end is a portfolio of some of the best mutual fund schemes in the industry. However, it should be well understood that not all FoF schemes will offer an attractive investment proposition. Investors are best placed to benefit if they are invested in a well-managed FoFs scheme. Fund of Funds offer investors a unique and excellent investment proposition.