FUND FLAVOUR
February 2011

Hit the bull in the eye…

Mutual fund investments have gained a lot of popularity in the last two decades, primarily by virtue of their ability to reduce risks, provide greater diversification and beat market volatility to a certain extent. But with a plethora of schemes available in the market, how do you choose the right one or diversify among the different schemes? The answer could well be 'fund of funds'.

…with Fund of Funds

In simple words, a fund of funds is a mutual fund which invests in other mutual fund schemes. Where a traditional mutual fund comprises of a portfolio of shares, a fund of funds comprises of a portfolio of different mutual fund schemes. The process of investing in fund of funds is similar to investing in other mutual funds. For the amount invested, units are allocated on the basis of the NAV of the scheme. The performance of the FoF is linked to the NAV movement of the underlying mutual fund schemes, in which the FoF has invested. Fund of funds invest in mutual funds on the basis of an investment objective, such as aggressive, conservative etc. The right funds to invest in are chosen by the fund manager.

Weighing the scales…

Does it make sense to invest in FoFs? Let us look at the various issues associated with FoFs.

Diversification

Just as a mutual fund scheme offers diversification by investing in various equity scrips, a FoF offers diversification by investing in various mutual fund schemes. Experience of the past few years, shows that the top performers are usually different from year to year. However, there are certain funds, which have been consistent performers. Therefore, a FoF that invests in say 4-5 of the top ten funds today is expected to yield better returns than say investing in the top performing fund of the day. Secondly, you get a chance to diversify across various fund managers and investing styles. Thirdly, even if a fund manager quits one AMC and joins another whose fund you already own in the FoF, you are not affected by this constant movement of the fund managers.

Convenience

As a prudent investor, you would like to diversify your investment across both equity and debt funds. By choosing a suitable FoF, you get a chance to invest across different class of funds with just one investment. Thus, it becomes very convenient for investing and monitoring. You need not keep track of multiple mutual fund schemes and their performances. You would have only one folio to maintain and one NAV to keep track of. Moreover, suppose you wanted to invest in 2 equity funds and 2 debt funds, assuming each fund has a minimum stipulated investment of Rs 5,000, you would need Rs 20,000. In a FoF, Rs 5,000 would suffice.

Rebalancing

This is a double deal that a FoF offers. Suppose you have Rs 100 to invest and your debt-equity allocation is 30:70. After one year the Rs 30 in debt has grown to say Rs 32.40 @8% p.a. and the Rs 70 in equity to Rs 94.50 @35% p.a. The debt-equity allocation has now become 25.5:74.5. Thus the portfolio has become riskier than your profile of 30:70. Therefore, you need to sell Rs 5.67 of equity and invest in debt to bring back the debt-equity ratio to 30:70. Conversely, say after one year the debt has grown to Rs 32.40 @8% p.a., but equity portion suffered a loss of 20% and reduced to Rs 56. The debt-equity ratio changed to 36.7:63.3. Now you need to sell Rs 5.88 from debt and put into equity. This rebalancing will involve capital gains tax, if you do it by holding individual mutual funds. When a FoF does it, there is no long/short term capital gains tax, which can be as high as 30% on short-term capital gains in a debt-fund. This is a big benefit. The second benefit that FoF rebalancing offers is a psychological one. Usually people do not sell when the markets are rising and do not buy when the markets are falling. Yet, this is exactly what you should be doing. FoF does it automatically (and it usually can be in your long term interest).

Cascading costs cornered

Market regulator the Securities and Exchange Board of India (SEBI) has restrained fund houses from following a two-level fee pattern while launching FoFs. The regulator has capped total expenses for launching a FoF at 2.5%, which will include fund management fees not exceeding 0.75% and charges levied by target or master fund (the recipient fund). The regulation will restrain fund houses from entering into revenue-sharing arrangements with their fund management partner, as was the case in FoFs. Fund houses used to charge investors at two levels — one while investing in the source fund (or feeder fund), and for a second time when the source fund invests in a target fund. By restricting revenue sharing, the regulator intends to stop charging asset management charges at two points. If one details the cost structure of FoFs, fund houses pays for marketing expenses, registrar fee and distributor commission from the 75-bp commission charged from investors. The partnering fund management company (the master fund managers) allows the source fund (FoF) 75 bps from the fund corpus as ‘marketing charges’ or ‘fund allocation charges’. The target fund, in turn, levies asset management charges between 1.5% and 2.5% (1.5% being in the case of investments into institutional class (I-share class) funds and 2.5% in the case of investments in A-share class (or retail class). This takes the overall intermediary expense on the fund to about 3.25%, which will have to be borne by the investor. In the case of domestic funds, AMCs levied fund management charges of up to 75 bps (each) on both feeder and master funds. With the cap on asset management fees in place, domestic funds will not be able to receive fund management charges on both feeder fund and master fund levels.

Taxes

As per the present tax laws, equity FoF does not enjoy the benefits available to a normal equity fund. Therefore, if you invested in an equity FoF you would be liable to pay dividend distribution tax (DDT) of 14.03% and LTCG tax of 10% (without indexation), which is otherwise NIL for a normal equity mutual fund. This higher tax can significantly reduce the post-tax returns. Once Direct Taxes Code is implemented from April 1, 2012 there will be DDT of 5% for equity mutual funds and STCG rates will be charged in the place of LTCG rates. DTC has linked the short-term capital gains tax to your annual income (taxed at half the normal slab rates).

Single AMC FoFs

Most FoFs were, till recently, not true FoFs. They invested only in the different funds of the same AMC, which promoted the FoF. Only recently, some FoFs have been launched which invest across different AMCs and hence are truly diversified.

The Roller Coaster ride

The first FOF was launched by Franklin Templeton Mutual Fund on October 17, 2003. Fund houses like DSP Blackrock, ICICI Prudential, Birla Sunlife, Franklin Templeton, and Fidelity have 21 FoF schemes with AUM of Rs 3010 crore as of December 31, 2010, according to AMFI data. This is a seven-fold increase from a mere 3 schemes in 2003. But FoFs in India have traversed a chequered path with the number of FoF schemes and the AUM following a wave-like pattern.

The awakening?

Due to their collective nature, fund of funds type of investments experience a wide range of diversity. Fund of Funds can be Sector specific e.g. Real Estate FOFs, Theme specific e.g. Equity FOFs, Objective specific e.g. Life Stages FOFs or Style specific e.g.Aggressive/ Cautious FOFs etc. Increase in diversity translates to relatively low risk as well as high rates of returns from the various securities. The primary objective of FoF is to provide greater diversification, at reduced risks and ease the process of fund selection for investors. New or first time investors, who do not have large capital for a diversified portfolio, could now diversify from among thousands of funds and stocks, with a small amount of money. Thus, if you lack the time, inclination, and expertise to monitor the market or mutual funds and are unable to take informed decisions, fund of funds could be the ideal choice for you.