Fund of Funds

Starting in 1993, when private-sector mutual funds made an entry in India, the Indian mutual funds business has undergone a dramatic transformation. By the year 2000, there were about 22 mutual funds with about 90 equity schemes on all. And today, there are around 35 mutual funds with about 320 schemes. Another dozen fund houses are set to make an entry in the coming year.

For the lay investor, making the right choice to invest in good schemes has become quite difficult. Expecting investors to make an informed decision to choose the relevant schemes amongst the 320 odd equity funds is like asking them to find a needle in a haystack. This confusion is bound to grow further, as fund houses to widen their product baskets continue to introduce new and different funds at an aggressive pace. To reduce this confusion and help investors make the right choices, the concept of “Fund of Funds”(FoF)as evolved.

A relatively new concept in Indian mutual funds scenario, a Fund of Funds aims at generating returns by investing in a portfolio of other mutual funds. Unlike regular funds, which invest directly in shares, bonds and other securities a Fund of Funds invests in the units of other equity or debt mutual funds or both. Thus, gains or losses from a Fund of Funds are directly proportional to the appreciation or decline in the NAV of the underlying funds. This method is also known as “multi-management”. Simply put, instead of trying to find the needle in the haystack, an investor can pass on this responsibility to a fund which will then invest in a host of other mutual fund schemes with a proven track record.

For retail investors to invest directly inequity funds requires loads of time and energy in researching the various funds and their past performance, along with having the requisite skill to identify the good schemes which would have a great long term potential .This is not just difficult, it is almost impossible. As the number of schemes goes on increasing, investors will find it more and more difficult to separate the wheat from the chaff.

After identifying and investing in mutual funds come the task of tracking the portfolio, for the investor to check whether the funds are performing well, and whether some of them are duds that need to be replaced by something better. In FoF the onus of tracking the performance of various mutual funds schemes, churning the portfolio, and so on, is on the fund manager of the particular FoF. Thus, FoFs are very convenient to handle, because they reduce the number of funds investors need to manage.

There are several other advantages to investing in a FoF. For starters, the investors does not have to pay short term or long tern capital gains whenever the FoF switches from one fund schemes to another fund – costs that one would normally incur when changing normal mutual funds. Another significant advantage is that whenever the FoF switches from one scheme to another the investor does not have to bear the entry load, as the FoF does pay the same. This translates into significant long term which he would not have enjoyed funds through the normal fund route.

Depending on what kind of FoF one invests in, another big advantage is diversification. A fund of Funds ensures that the investor’s portfolio be diversified across various schemes, different asset classes such as equity, debt, and so on, different sectors and investment styles, in the widest possible range. Thus, a FoF takes diversification to an altogether new plane. Wider diversification may also translate into lower risks for the investors.

A significant disadvantage of FoF investing is in the area of taxation. As per the regulations of the Securities and Exchange Board of India, all FoFs are treated as debt mutual funds for taxation purposes. Thus, an investor in an equity FoF is subjected to short term capital gains tax at the rate of 33.99%, as against 11.33% in case of equity mutual funds. Similarly for long terms capital gains, an investor in an equity FoF is required to pay 22.66% with indexation benefits, or 11.33% without indexation benefits, whereas long term capital gains accrued in an equity mutual fund is exempted from tax. Again unlike equity funds where dividends are tax free in the hands of the investors, dividends from equity FoF are taxed like those from debt funds at the rate of 14.16% for individual investors. Thus whatever gains an investor makes in FoF is largely negated by taxation.

Another major area where FoF schemes draw criticism is the incremental costs they impose on the investors. Regular equity mutual funds on an average have an expense ratio of around 200 basis points, while FoF schemes on an average have an expense ratio of 25-75 basis points, which is over and above the expenses ration of underlying funds. Thus, any higher returns generated by FoF may be reduced by the higher costs that may be charged to investors.

FoF schemes can be categorized on the basis of their structure as well as their asset allocation. Structure wise, these schemes can be classified into open ended or close ended funds. In terms of asset allocation, they can be loosely classified into variants of diversified equity, balanced and MIP (monthly income) schemes, depending upon their exposure to equity and debt mutual funds. Another category of FoFs consists of schemes which invest in units of overseas equity mutual funds. Sundaram BNP Paribas Global Advantage Fund and DWS Global Thematic Offshore Fund are two FoFs that invest in foreign mutual funds.

The year 2003 saw the initial FoFs being launched by Franklin Templeton India Mutual Fund and ICICI Prudential Mutual Fund. The following year saw a host of FoFs being launched by various fund houses, including the Birla Mutual Fund, Kotak Mutual Fund, and Optimix Mutual Fund. The growth of the FoF category however, has been fairly modest, with the cumulative corpus of FoF schemes totaling just over Rs 2,000 crore as of October 2007.

With the history of FoF being rather short, it is difficult to judge them based on their performance, but the FoF schemes launched by Kotak Mutual Fund, ICICI Prudential and Optimix have done reasonably well. Until the anomaly in taxation is corrected FoF schemes especially equity ones may not attract sufficient investor attention.