FUND FLAVOUR

February 2019

Fund of funds (FoFs) is one of the best mutual funds for investors whose investment amounts are not too large and it is easier to manage one fund (a fund of funds) rather than a number of mutual funds. In this form of mutual fund investment strategy, investors get to hold a number of funds under the umbrella of a single fund, hence the name fund of funds. Often going by the name of multi-manager investment, these funds enable investors to diversify themselves across a gamut of mutual fund schemes at a lower ticket size.

What are Fund of Funds?

In simple words, a mutual fund investing its collected pool of money in another mutual fund (one or maybe more) is referred to as fund of funds. Investors in their portfolios take exposure to different funds and keep track of them separately. However, by investing in multi-manager mutual funds this process gets more simplified as investors need to track only one fund, which in turn holds numerous mutual funds within it. Assume an individual has invested in 10 different funds having exposure to various financial assets like stocks, bonds, government securities, gold, etc. However, he finds it difficult to manage those funds as he needs to keep track of each fund separately. Therefore, to avoid such hassles, the investor invests money in a multi-management investment (or a single fund of funds strategy) which has its stakes in different mutual funds.

The Modus Operandi…

An FoF is a mutual fund scheme that invests in other mutual fund schemes. It works like this: you invest in a mutual fund because you do not have the time, wherewithal and patience to go through individual companies’ financial statements and to understand their business dynamics to be able to successfully invest in their shares. Your fund manager does the research and picks stocks and sectors to invest in. But, you still need to select your mutual fund. Out of roughly 2,000 mutual fund schemes across equity, debt, gold, foreign equities and so on, on the street today, how do you make a basket of 6-10 mutual fund schemes, which is an ideal number to have in your portfolio? Some have financial advisers and distributors to help. But for others who wish to go direct, and yet do not have the time or wherewithal to select mutual fund schemes, an FoF does the job for you. Your FoF fund manager tracks the mutual funds industry and shortlists, what he believes is an, investment-worthy list of schemes after due research, and puts all your money there. An FoF can be equity-oriented, debt–oriented or a swing between both equity and debt mutual funds. Additionally, some FoFs also invest in gold funds.

For understanding the modalities of how multi-manager investment functions, it is important to understand the concepts of fettered and unfettered management. Fettered management is a situation when the mutual fund invests its money in a portfolio containing assets and funds managed by its own company. In other words, the money is invested in the funds of the same asset management company. In contrast, unfettered management is a situation where the mutual fund invests in external funds managed by other Asset Management Companies. Unfettered funds have an advantage over fettered funds as they can exploit opportunities from numerous funds and other schemes instead of limiting themselves to funds of the same family.

The FoF flavours on a platter…

Of the many fund of funds available in India, the four most sought-after FoFs include:

Asset Allocation Funds

Asset allocation funds are mutual funds that invest in a varied class of assets. These assets range from equity-oriented, debt-oriented or even other asset classes like gold, other metals, and commodities.

Gold Funds

These funds invest in various forms of gold, be it in the form of physical gold or in the form of stocks of gold mining companies.

Foreign or International Fund of Funds

International funds are investments in mutual funds comprising bonds and stocks of international companies.
Multi-manager Fund of Funds

A multi-manager fund is one that comprises of many professionally managed funds but is a single portfolio.

The Pros…

Tax-Friendly

If you wish to rebalance your assets, there will be no tax on capital gains for this internal transaction. Therefore, when your Fund of Funds is rebalanced to maintain a said allocation between debt and equity there will be no tax on capital gains. Most fund of funds launched in India have seen muted investor interest because of their tax disadvantage vis-a-via equity funds. While dividends and long-term capital gain (LTCG) from equity schemes were tax free till last year, investors were forced to pay tax on LTCG from FoFs, even if the FoF portfolio comprised equity funds. However, with the Budget 2018 introducing a 10% tax on dividends as well as LTCG (without indexation benefit) from equity funds, FoFs’ comparative tax disadvantage has been levelled, which is now drawing investors’ interest in these funds. In fact, now FoFs have a distinct advantage over equity mutual funds as they can shuffle the funds in their portfolio without any tax incidence. As FoFs have pass-through status, their buying and selling of mutual funds does not result in a tax incidence. This works best for dynamic FoFs. Since there will not be any tax incidence till the FoF is redeemed, it will help investors compound their wealth without any interruption. 

Professional Fund Management Services

Investing in Fund of Funds allows you to try out investing in professionally managed funds before they can venture out on investing individually.

Ease of Handling

There is just one NAV to track and just one folio. This makes it easy to handle the reduced number of funds that require managing.

The Credibility of Portfolio Managers

Fund of Funds are expected to follow a due diligence process conducted by the fund manager where they need to check the background and credentials of the underlying fund managers before making an investment to ensure that the strategy is in-line with expectations. 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 of 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.

Opportunity for investors with limited capital

A 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, bonds, gold, equity, and debt. Such a portfolio combination is rarely found in the average mutual fund. This is a good option for retail investors who wish to venture into this investment avenue with a lower ticket size.

Gateway for diversified assets 

One of the key primary benefits is portfolio diversification. Here, despite investing in one single fund, the investment is made in several mutual fund schemes, where the fund is allocated in an optimal manner with the aim to earn maximum returns at a given level of risk. Multi-management investment helps retail investors to get access to funds that are not easily available for investments. A single fund of fund can take equity funds, debt funds or even commodity based mutual funds. This ensures diversification for the retail investor by just getting into one mutual fund.

…and the Cons

High Expense Ratio

Fund of Funds incur expenses just like any other mutual fund schemes. But unlike mutual funds, there is extra cost involved. Apart from the usual management and administrative costs, there is an added expense pertaining to the underlying funds.

Tax implications

If you get a dividend in excess of Rs. 10 lakh, there is an income tax of 10%.

Too much diversification

Fund of Funds invest in many funds which further invest in a number of securities. This gives rise to the possibility of the Fund of Funds ending up owning the same stocks and securities through different funds. This reduces the potential for diversification.

FoFs in pure equity mutual funds – facing extinction?

What is unique about Quantum Equity Fund of Funds? It is the only remaining mutual fund scheme—specifically, a fund of funds scheme—that invests its entire corpus in equity mutual funds and those that belong to other fund houses. But there was a time when a few other such schemes did the same as well. What happened to them and why did they wither away? FoFs used to suffer in terms of taxation. Equity funds did not attract long-term capital gains tax if you sell units in them after a year. The short-term capital gains tax is just 15%. Also, dividends were tax-free. But debt funds attract short-term capital gains—at income-tax rates—if you sell them within 3 years. After 3 years, debt funds attract a long-term capital gains tax applicable at 20.6%, with indexation benefits. FoFs were always considered on par with debt funds for taxation purpose. Even if your FoF was in equity, you were, and still are, subjected to debt fund taxation. Fund houses waited for some years to get this anomaly corrected. But it never happened. At one time, there were a few schemes that invested in just equity mutual funds. For instance, ING OptiMix Equity Multi Manager FoF and ING OptiMix Equity Multi Manager FoF–Series II. Kotak Mahindra Asset Management Co. Ltd too had one such scheme called Kotak Equity FoF that used to invest in just equity schemes. In 2008, Optimix wound up and got merged into ING mutual fund. In 2014, Birla Sun Life Asset Management Co. Ltd acquired ING Investment Management (India) Ltd. According to Value Research, both the above Optimix schemes were redeemed in 2009-10. Meanwhile, Kotak Equity FoF became Kotak Asset Allocator in 2014 and started investing in the fund house’s own equity and debt schemes, though according to its offer document, it can still invest its entire corpus in equity schemes. That leaves Quantum Equity FoF as the only one that invests in equity mutual funds and also outside of its own fund house.

 

FoFs – how have they fared?

In the past one year, DHFL Pramerica Global Agribusiness Offshore Fund topped the list of FoFs in India with a return of 13.7%, followed by Aditya Birla Sunlife Global Real Estate Fund with a return of 12.9%, Franklin India Feeder – Franklin US Opportunities Fund at 12.1%, HSBC Brazil Fund at 11.6% and Axis Gold Fund at 10.1%.

FoFs – do they suit you?

While FoFs have become relatively attractive, there is no need for investors to rush into them. Investors need to see if the objective of the FoF is in line with their investment objective. The FoF structure works better for investors who follow strict rule-based investing. For instance, there are some FoFs whose asset allocation is strictly based on Nifty PE—Franklin India Dynamic PE Ratio FoF is one such scheme. So, if you too are a strict rules-based investor, then instead of taking the trouble of revising your equity allocation based on, say, Nifty PE, which will involve redemptions and hence tax on gains, you can simply invest in FoFs for the long term. How has the investing strategy based on Nifty PE worked? Franklin India Dynamic PE Ratio FoF has generated a return of 10.01% over the past 10 years, comparable to the large-cap equity fund category average of 10.45% over the same period. But Franklin India Bluechip, the equity fund in which Franklin India Dynamic PE Ratio FoF invests, has delivered 11.49% return during the past 10 years. Since the long-term return of the underlying fund is higher, should you invest in the FoF instead? The answer lies in the risks associated with the two schemes. The strategy of reducing the equity component during high market valuations has reduced the risk of the FoF significantly. While the annualised standard deviation (a measure of the volatility in the fund’s return) of Franklin India Bluechip is 22%, it is just 14% for the FoF. However, FoFs are not the only schemes that lower risk by changing their asset allocation. For asset allocation strategy, investors can also use asset allocation funds instead of dynamic FoF. While investors may appear to lose control over their portfolios by investing in FoFs, it should not be a cause of concern since rule-based FoF will be better at executing the strategy and at price discovery (compared to individuals investing in equity mutual funds). 

Fund of Funds can be a good investment choice for an investor with limited experience and limited funds. Fund of Funds like mutual funds are subject to market risk and therefore, the investor should acquaint himself/herself with the market risks and the strategies of investment. Fund of Funds rely on the principle of deriving the maximum benefit out of single but diversified investment plans. Select an experienced fund manager and know your risk tolerance, transactional timelines, tax implications, etc. As an informed investor you must weigh the pros and cons of FoFs before making any investment decision.