FUND FLAVOUR

February 2020

Fund of Funds – telling the wood from the trees

Fund of funds 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. 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 in various financial assets like stocks, bonds, government securities, gold, etc. However, he finds it difficult in managing those funds as he needs to keep a 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. 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 funds of funds. So, instead of investing directly in an asset class, a fund manager invests through a scheme which is already invested in that class. For instance, if a fund manager intends to invest in gold, he will invest in a gold scheme which invests in gold. This means a FoF does not have shares or bonds of a company. Instead a FoF holds units of other schemes.

The modalities

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 the same family funds. These can belong to the same mutual funds as the FoF or belong to different mutual fund houses. At present, the FoFs offered in India belong to the same fund house. Just like other mutual fund schemes, a FoF will also have its expenses. Regulations permit a FoF to charge 0.85 per cent as expenses. If this is added to the 2.5 per cent, the maximum expense ratio that an equity fund can charge, then the total cost of this offer can be as high as 3.35 per cent. Expenses will, however, be the only area where a Fund of Fund will be charging anything extra. Loads will be levied only when the investor buys into a FoF and not when the FoF itself invests in the underlying funds.

Groups galore

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

§    Asset Allocation Funds

These funds consist of a diverse asset pool – with securities comprising of equity, debt instruments, precious metals, etc. This allows asset allocation funds to generate high returns through the best performing instrument, at a reduced risk level guaranteed by the relatively stable securities present in the portfolio.

G      Gold Funds

Investing in different Mutual Funds, primarily trading in gold securities are 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. Fund of funds belonging to this category can have a portfolio of Mutual Funds or the gold trading companies themselves, depending upon the concerned asset management company.

§       International fund of funds

Mutual Funds operating in foreign countries are targeted by the international fund of funds. International funds are investments in mutual funds comprising bonds and shares of global companies. This allows investors to potentially yield higher returns through the best-performing stocks and bonds of the respective country.

§        Multi-manager fund of funds

This is the most common type of FoFs available in the market. A multi-manager fund is one that consists of many professionally managed funds but is a single portfolio.

The asset base of such a fund comprises of various professionally managed Mutual Funds, all of which have a different portfolio concentration. A multi-manager fund of funds usually has multiple portfolio managers, each dealing with a specific asset present in the Mutual Fund.

§       ETF Fund of Funds

Fund of funds comprising exchange traded funds in their portfolio is a popular investment tool in the country. Investing in an ETF through fund of funds is more accessible than a direct investment in this instrument. This is because ETFs require Demat trading account while investing in ETF fund of funds has no such limitations. However, ETFs have a slightly higher risk factor associated with them as they are traded like shares in the stock market, making these FoFs more susceptible to the volatility of the market.

 

The good…

There are various benefits of investing in a Fund of Funds –

§        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.

§      Tax friendly

In case you wish to rebalance your assets, there will be no tax on capital gains for this internal transaction. Thus, when your Fund of Funds is re-balanced to maintain an allocation debt and equity, there will be no tax on capital gains.

§       Ease of handling

With just one NAV (Net Value Asset) and one folio, it is easier to handle the reduced number of funds that require managing.

§       Opportunity for investors with limited capital

It also allows investors who own little capital to partake in diversified funds that have underlying assets. If not, these assets otherwise would be hard for investors to access individually.

..the bad and the ugly

§       Expense ratio

Expense ratios to manage FoFs are higher than standard Mutual Funds, as it has a higher managing expense. Added expenses include primarily choosing the right asset to invest in, which keeps on fluctuating periodically. This expense amounts to a substantial amount, and is deducted from the annual returns generated by the asset management company.

§      Tax

Tax levied on a fund of funds are payable by an investor, only during redemption of the principal amount. However, during recovery, both short-term and long-term capital gains are subjected to tax deductions, depending upon the annual income of the investor and the time period of investment. It should be noted that the dividend received on the investment is not taxable, as the burden is borne by the issuing fund house.

§       Involves too much diversification

Fund of Funds is built in such a way that it is invested in many funds which is invested in a number of securities. It also possibly proves that Fund of Funds end up owning the same stocks and securities through different funds. Therefore, it reduces the potential for diversification.

 

Still a fledgling in India…

FoFs as financial instruments started getting traded in the American market since the 1980s. However, in India, SEBI permitted fund houses to launch FoFs only in the middle of 2003. The first fund of funds in India is FT India Dynamic PE Ratio FoFs launched by Franklin Templeton mutual funds in October 2003. Currently, 44 AMCs and more than 50 schemes are in operation. Fund of funds is available as a distinct product in the Indian mutual funds space. But the concept of FOF has not really picked up in a big way in India. If you look at the more developed markets of Asia, Europe and the US, the FOFs are primarily used as a source of providing advisory services to the customers. The reasons are not far to seek. You have FOFs on equity, debt, gold, metals and even on global indices. As an investor you just need to tweak your FOF mix in such a way that you are able to create a diversified portfolio that is not only opportunistic but also gives you the best risk-adjusted returns. All that is possible with FOFs! In India, FOFs have typically predominated in the area of international funds. Indian AMCs with global affiliations used to structure FOFs in such a way that they would collect funds from Indian unit holders and reinvest the funds in the global index funds of their international partners. This gives international diversification to the domestic portfolios and also gives investors an additional asset class to invest. The international funds have been preferred because they are not exactly correlated with the local markets.

…looking at interesting ways to put FoFs to use

FOF offers indirect participation in ever alien markets and complex markets where you can use the FOF as an allocation mechanism. FOFs can be your ticket to participate indirectly in global markets. Most investors are either predominantly or entirely exposed to the Indian market and are constantly worried about a possible downturn in the Indian markets. The fund performance could get negatively impacted. That is where the international funds (FOFs) come in handy. They give you the ability to take positions in beta-only global indices so you obviate the company specific risks. Additionally, the global index also saves you the hassles of currency risk. Secondly, you have a wide choice of FOFs available to you in the market. In fact, there is a virtual array of FOFs available to you in the global market. FOFs offer you a wide choice of international markets and international asset classes. You get an automatic hedge into your portfolio. For example, at a time when the dollar is rapidly strengthening, you can use international FOFs on US indices to give you the dollar advantage. There are FOFs you can invest that are dedicated to commodities like gold, silver and other asset classes. This helps you to participate in the commodity up cycle and also de-risk your portfolio risk which is predominantly tilted towards equities. Then, of course, there are FOFs which invest predominantly in commodity indices or bond indices so you do not take the specific risk but you can invest in themes. For example, you can get ETFs to trade in themes like ferrous, non-ferrous, precious metals, industrial metals, energy, clean energy, credit quality, distressed assets, long duration etc. In India, FOFs are not used very aggressively in financial planning but across South East Asia, Europe and the US these FOFs are quite popular as financial planning tools. As a financial planning tool, FOFs are unmatched. If you have decided to opt for a financial solution based fund for your retirement or your child’s education, then FOF is what you are getting into. Most of these solution oriented funds are nothing but FOFs. In more matured markets, FOFs are a very important tool of financial planning. Essentially financial planning is about achieving your goals through intelligent asset allocation. But what do you do if you are not able to get your appropriate mix. That is where FOFs can come in handy. In other countries advisors purely specialize in combining FOFs to give you the risk-return matrix that is suited to your unique requirements. Using FOFs for financial planning is not only economical but also intelligent because you are getting the flexibility to meet your financial goals in the simplest possible manner. FOFs make your portfolio non-directional and better diversified. Long term portfolios normally tend to be long only portfolios. That is the catch. You are stuck to long positions even when markets correct sharply with the result that you spend a lot of time recovering your losses and recouping the MTMs. In FOF based investing, you can tweak your portfolio by just tweaking from one FOF to another. You have a choice between debt, commodities, energy, precious metals, global indices, bond indices etc. The disadvantage of an FOF in the Indian context is its tax treatment wherein the FOF is treated as a non-equity fund even if it is a fund of equity funds. That is a major anomaly and the fund industry has been trying to reason with the IT authorities to change that. Effectively, FOFs will be treated as short term gains if held for less than 3 years and long term gains only beyond that. In case of FOFs, the STCG is payable at your peak tax rate and the LTCG is payable at 20% after indexation. Unless this anomaly is rectified, FOFs may not really attract the attention of investors and financial planners in India. There is also an aspect of cost in FOFs because costs tend to get loaded on the end customer at two levels. This is again something SEBI must look to tweak favourably.

Best fit for DIY investors

The main aim of fund of funds is to maximise returns by investing in a varied portfolio posing minimal risk. Individuals with access to a small pool of financial resources which they can spare for a more extended period of time can choose such a mutual fund. Since the portfolio of such funds consists of varying types of Mutual Funds, it ensures access to high-value funds as well. Ideally, investors with relatively fewer resources and low liquidity needs can choose to invest in the top fund of funds available in the market. This enables them to earn maximum returns at minimal risk.

The FoF as a product seems perfect for an investor looking to separate the wheat from the chaff, given the plethora of funds types to choose from. But here a professional fund manager does the job of selection, monitoring and rebalancing in a more efficient way. While selecting schemes, the fund manager is better able to track duplication of stocks and sectors across schemes. Since capital gains would be taxed on each switch from one scheme to another, you will have less capital being reinvested and compounding every time you switch schemes. The eventual impact of this on your corpus would be quite large. However, when the equity FoF exits an underperforming scheme and buys into a better performing one, mutual funds being pass through vehicles, it is not liable to pay any tax on the gains, thus keeping your capital intact for reinvestment. But there are caveats, too, that investors have to keep in mind. All the schemes that are included in the portfolio must match the risk and return preference of the investor. A compromise on any of the schemes may lead to a situation of the fund being too risky or very low on returns. The costs are another aspect to be closely watched; both the FoFs as well as the underlying schemes have to be disclosed under the regulations. The Quantum Equity FoF, for example, has an expense ratio of 0.51% under its direct plan and inclusive of the underlying schemes, it stands at 1.51%. Frequent switching of underlying schemes and the investor’s comfort with that strategy is another fund behaviour that needs scrutiny. Investors who work with advisors may not find much use for this product. But for investors who are looking to build their own long-term portfolio, there may be some merit in considering these structures.

Fund of Funds invest in other mutual fund schemes but do not directly invest the money into assets such as debt securities or equity shares. Effectively there are debts FOFs as well as equity FOFs and their taxation will now differ. This is contrary to the previous situation where all FOFs irrespective of the underlying asset class get taxed as per debt fund taxation. This will be a boost for financial planning through FOFs which is very popular among financial planners across developed markets. It is surely a good start!

The final call

FoFs make sense for retail investors who do not have access to the know-how needed to take decisions regarding asset allocation. For laymen investors, FoFs -which invest in both equity and debt and rebalance portfolios based on market conditions - would make sense. More sophisticated investors could also consider FoFs, because they provide access to themes which are not available in India, and therefore allow diversification. Those looking for one-stop solutions should consider such funds; however, they should also consider their risk appetites and investment objectives beforehand. However, if you want full control over your investments, you should invest directly in mutual fund schemes.