FUND FLAVOUR

November 2020

Fund of Funds

A scheme that invests in other mutual fund schemes of the same fund house or another fund house is known as Fund of Funds. Instead of investing directly in equities or bonds, the fund manager holds other mutual funds in his portfolio. The portfolio is designed in such a way that it will suit investors across risk profiles and financial goals. The investors can avail the opportunity to benefit from diversification as investment is spread across numerous fund categories, and risk is reduced. The ultimate objective of the scheme is to create wealth over the long run.

Types of Fund of Funds

1. Fund of Fund Investing Overseas

This type of Fund of Fund (FoF) invests in international funds which are registered in foreign countries. These foreign funds, in turn, hold foreign stocks. This way the FoF enables Indian investors to get exposure to foreign stocks such as Alphabet (Google), Apple, Microsoft, General Motors etc. For example, DSP US Flexible Equity Fund invests in Blackrock Global Funds – US Flexible Equity Fund, an international fund managed by Blackrock.

2. Fund of Funds Investing in ETFs

FoFs also give investors access to ETFs. An ETF (Exchange Traded Fund) invests in stocks, bonds or commodities like gold. It is not sold like an ordinary mutual fund but is rather traded continuously on the stock exchange. However, Investors need demat and trading accounts to invest and trade in ETFs. This leaves out a large section of investors from the ETF market. As a result, mutual fund houses have created FoFs to give retail investors access to ETFs. For example, Nippon India Gold Savings Fund is a FoF which invests in India’s largest gold ETF, Nippon India ETF Gold BeES.

The pros...

Diversification

Fund of funds target various best performing Mutual Funds in the market, each specialising in a particular asset or sector of fund. This ensures gains through diversification, as both returns and risks are optimised due to underlying portfolio variety.

§      Professionally trained managers

Fund of funds is managed by highly trained people with years of experience. Proper analysis and calculated market predictions made by such portfolio managers ensure high yields through intricate investment strategies.

§      Low resource requirements

An individual with limited financial resources can easily invest in the top fund of funds available to earn higher profits. Monthly investment schemes can also be availed while choosing fund of funds to invest in.

 ...and the cons

·         FoFs charge double expenses

In addition to the expenses charged by the underlying schemes, FoFs charge an additional fee. Well, it is true that FoFs do charge an additional fee, but it is to defray the fund management costs and other expenses incurred. However, this fee is considerably low. Most FoFs charge an annualised fee of under 1.5% for the regular plan and under 1% for the direct plan. For some schemes, the fee is as low as 0.5%. FoFs cannot charge investors as per their whims and fancies. As per Regulation 52(6) of the Mutual Funds Regulations,1996, the total expenses of a FoF including the weighted average of charges levied by the underlying schemes shall not exceed 2.50% of the daily net assets of the scheme. Hence, the overall costs could be lower than certain equity mutual funds as well.

·         FoFs attract a tax liability

FoFs are classified as non-equity schemes, hence they do not enjoy the tax benefits of equity-oriented schemes. For FoF schemes, STCG for units held for less than 36 months, is added to the total income and taxed accordingly. LTCG attracts a tax of 20% with indexation. Equity schemes on the other hand attract Short-term Capital Gains (STCG) tax of 15%, while Long-term Capital Gains (LTCG) is tax free. The holding period is one year to be considered as LTCG. Clearly, the tax liability will eat into the returns of a FoF scheme. However, investors tend to overlook the fact that a FoF scheme has the potential to deliver far superior returns than most equity schemes. Hence, even if the post-tax returns are considered, FoFs could still outperform, as the scheme selection is backed by a robust research methodology.

·         Biased to in-house schemes

Fund houses may pick schemes that are managed by them for FoFs. However, this may not be the case, unless specified in the investment allocation specified under Section II of the Scheme Information Document (SID). The fund managers are expected to adopt an unbiased approach to pick funds that are not limited to their own fund house or a specific fund company. The scheme selection in most cases is driven by a comprehensive research methodology and market outlook.

Apt for...

The best part of Fund of Funds is the diversification of funds, which helps to reduce the risk. Therefore, it is a good option for small investors who do not wish to take higher risks. Ideally, investors having relatively fewer resources and low liquidity needs and having an investment horizon of five years or more may opt to invest in the top Fund of Funds available in the market. It enables investors to earn maximum returns at minimal risk.

Key criteria...

There are various factors which an investor should have complete information about before deciding to allocate his/her resources to these mutual funds:

·        Top fund of funds operate in the long term, thus locking your investment for a considerable period. You should make sure your liquidity needs are satisfied through other sources before choosing to invest in this type of mutual fund.
·        Even though the risk factor is minimized, thanks to quality management and diversification, they are always subject to volatility due to market fluctuations.
·        Due to high expenses and tax implications of fund of funds, the returns on investment in this scheme might be lower than the expectations of an investor.

FoFs yet to make its mark in India

Fund of Funds (FOFs) is a very popular concept in the West and even across Asian economies. Most institutions use the FOF approach to investing in mutual funds. In performance terms, these FOFs have failed to deliver. Anyway, an FOF focusing on global markets does not exactly add value when the whole world is looking to India for alpha. Secondly, FOFs also get unfavourable tax treatment. Even if an FOF aggregates equity funds, it is treated as a debt fund for tax purposes. That is a key reason why FOFs have not taken off in India.

The bottomline...

The holy grail of sensible investing is figuring out a good asset allocation and then rebalancing your portfolio dispassionately to stick to your asset allocation. With the advent of FoFs, this task could now be made much easier and of course less taxing.