FUND FLAVOUR

February 2018

Juggling its way…

Fund of Funds (FoFs) or multi-manager funds, as they are otherwise known, are funds which invest in other mutual funds. Fund of funds do not invest directly in stocks, bonds or other securities, but mandate asset allocation to other fund managers, who might be able to offer a variety of investment strategies. They allow broad diversification, appropriate asset allocation with investment experts in a variety of fund categories – appealing especially to small investors who want to get better exposure with fewer risks by protecting their investments from severe losses caused by uncontrollable factors such as inflation and counterparty default, compared with directly investing in securities. Technically, FOFs help diversify risk and look to make long-term returns but they charge higher management fees. In simple terms, instead of investing in securities directly, a multi-manager fund will invest in the best mutual fund 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. An FOF is essentially one mammoth fund holding a portfolio of other investment funds – but can it now be viewed as a potential game-changer in India’s mutual fund sector, after enjoying nearly two decades of sizzling growth around the world?

Good, bad and ugly

Fund of funds or multi-manager funds may sound fascinating but several positive and negative aspects can be ascribed to them.

Here are some of the benefits of FoFs:
·         Investors can track performance through one single window rather than accessing different accounts. In addition, it takes away the pain of deciding in which fund to invest.
·         Such funds offer fund manager and brand diversification since some FoFs invest in funds managed by different fund managers.
·         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. FOFs serve as an investor’s proxy. The fund of funds manager performs due diligence, and manages the selection process and oversight of the funds under their company’s management. Through a FOF, investors benefit from professional management services and also from greater transparency regarding the fund’s holdings and investment strategy.
·         The formal due diligence process allows FOFs to hire managers who have reputable experience in managing a portfolio of investments. The process entails conducting background checks of new fund managers to know their history and if they have ever been involved in activities that may affect the performance in the fund. The FOFs may contact security firms to conduct background checks, along with reviewing the manager’s credentials. Through this process, a fund may weed out managers with a bad reputation or a history of underperformance.
·         An FOF aims at diversifying the risk of a single fund by investing in several types of funds. An investor with limited capital can invest in one FOF and get a diversified portfolio consisting of, for example, gold, equity, and debt. Such a portfolio combination is rarely found in the average mutual fund. The FOF’s asset allocation mechanism reduces risk exposure with the aim of protecting investors from uncontrollable factors that may wipe away their investments. For example, if an investor only held bonds in a company that was later downgraded by a rating agency, the bond would decline in value. However, if an investor held a single FOF, his risk would be diversified across several investments.

But like everything, even multi-manager funds have their disadvantages: 

·         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 can avail indexation benefits after three years, wherein gains are taxed at 20% after adjusting for inflation during the tenure of the investment.
·         Although diversification is considered a favorable strategy for reducing risk exposure, it may not result in optimal gains because the process of selecting funds managed by a large pool of fund managers is a difficult task. Investments aimed at broad diversification tend to underperform during times when only one or two market sectors or asset classes are performing well. Investors should also understand that the past performance of the fund and its manager does not guarantee results in the future.
 

Results Matter

There are enough studies to suggest that more than 90% returns are determined by asset allocation and the rest by stock and bond picking skills. It is difficult to judge a product based on only one bull or bear cycle. Its robustness should be measured over at least two full cycles.

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

While some of the Equity-oriented FoFs and Gold FoFs incurred losses, almost all the hybrid and debt-oriented FoFs raked in profit. In the Equity-oriented FoF category, Principal Global Opportunities Fund is the front-runner earning 33.8% followed by Quantum Equity FoF at 27.1% and HSBC Managed Solutions Growth Fund at 24.3%. In the Hybrid FoF category, Invesco Pan European Equity Fund at 22.9%, Invesco Global Equity Inc. at 20.9% and ABSL FP FoF at 20.4% are the toppers while ICICI Prudential Dynamic Accrual Plan at 6.2%, IDFC All Seasons Bond at 5.3% and HSBC Managed Solutions Conservative Fund at 4.5% are the toppers in the Debt-oriented FoF category.

…into the world of Asset Management?

Theoretically, FoFs may seem appealing but that may not necessarily be true. This is because not all funds normally invest in schemes of other fund houses. While some funds known as Fettered Funds invest in in-house schemes only, Unfettered Funds 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. Advisors are not enthusiastic about such products and say that investing in equity and debt funds separately is more useful than investing in FoFs. But FoFs cannot be written-off in general…..opt for well-managed funds in this category.