FUND FLAVOUR
February 2012

Simplicity in the midst of complexity

Mutual fund investing today has become complex and stressful. Investors need to choose from thousands of funds, closely track their performance, take decisions to retain or change funds, attract tax liability if funds are changed before 12 months and finally, reconcile all these holdings at the end of the year. These are real concerns of investors today. Fund of Funds simplify all this in an instant. Globally, investor awareness of multi-manager fund of funds is widespread. India too has multi- manager fund of funds though investors do not have sufficient awareness of these. When markets behave like they have been doing lately, the one who loses less is called a winner. Fund of Funds by their very design are meant to lose less. Still, only one per cent of the Indian Mutual Fund Industry's AUMs are made up of Fund of Funds.

Building blocks of awareness

But first, what is a Fund of Funds? At its simplest — a mutual fund that invests in other funds is a fund of funds. Conceptually it does what you do, create a portfolio of funds. The difference being, when you buy funds yourself, you buy them individually and hold and track and access them separately, while when you buy a fund of funds, you hold just one fund which in turn holds other mutual funds inside it. Two structures of multi-manager funds facilitate risk reduction - one is FOF, short for Fund of Funds, another is MOM or Manager of Managers.

FOF

The most prominent feature of the FOF is that instead of being invested directly into underlying securities, they are put into a single fund at first and then the money will be spread over several underlying funds. The credentials of every underlying fund are evaluated on the basis of its previous performance, asset classes, risks involved, and most important of all, the performance of the funds’ managers. The portfolio will be constructed based on the factors mentioned above. At present there are 108 FoF schemes, of which 70 are equity ones, 31 debt and 7 in the hybrid category.

MOM

Unlike Fund of Funds which adopts the method of diversifying the funds across several managers, the Manager of Managers fund is run by multiple fund managers of a single fund. It is also called segregated mandate, in which every manager has some expertise in some specific asset class. In principle, this method manages to spread risks by distributing the responsibilities among a number of fund managers. In addition, it allows a general fund manager to introduce specialization in different asset classes in order to achieve the maximum income.

The verdict

The advantages of FoFs far outweigh the disadvantages. FoFs are a great way to start investing into mutual funds for a first time investor. In a FoF investment, in principle, all eggs would not be put in one basket leading to greater diversification, hedging investor risk across various sectors. The fund manager would automatically switch between funds, in line with the investment objective of the scheme without the investor attracting capital gains tax or exit load. Investors would have only one folio to maintain and one NAV to keep track of. New or first time investors, who do not have large capital for a diversified portfolio, could diversify from among thousands of funds and stocks, with a small amount of money. With the FoF scheme, an investor gets access to such funds which are otherwise off limits for small investors. When a fund of funds manager changes any fund it has invested in, there is no tax liability that accrues on the investor. Expense fees and management costs are higher than normal mutual funds, as the cost structure will include the fees of the underlying mutual funds, as well as that of the the FoF. There is a possibility that the FoF may be holding the same stock through different funds it has invested in. The investor will have to bear a dividend distribution tax similar to a debt mutual fund.

Hence given the aforementioned pros and cons, a FoF scheme is a worthwhile investment proposition for:

· Small investors willing to build a portfolio of quality mutual funds
· Investors who are new to mutual funds and lack the resource of researching and choosing the right funds
· Investors who want to eliminate the cost incurred on research and advise on investment in regular mutual funds
· Investors who want to eliminate the hassle of maintaining and tracking their investment in multiple schemes

Changing perception

Many investors lack the time, inclination and expertise to monitor the market or mutual funds. In such cases too, fund of funds comes as the perfect investment tool. As far as their performance is concerned, most equity oriented FoFs led by the domestic equity oriented ones have delivered luring returns across time frames and also managed their risk well (as revealed by their Standard Deviation) which thus has resulted in them providing appealing risk-adjusted returns (as revealed by their Sharpe Ratio). The return of a fund of funds will always be closer to the weighted average returns of the funds it has invested in, quite like the return of an investor’s portfolio of funds. And by the very same logic, a fund of funds will not go down as much as the worst performing fund it holds inside it. For this very reason, fund of funds are known to give superior risk adjusted returns. Second, fund of funds until very recently were perceived as competition by distributors. If one single fund of funds itself can buy, hold, sell, overweight, underweight the funds it invests in, then how will a distributor add value to the investor! This misplaced perception has begun changing in the last one year. Fund of funds industry AUMs have more than doubled in the last 15 months to over Rs 8000 cr as of October 2011.

Building portfolio the efficient way!!

Building an efficient portfolio of wealth creating mutual funds is often seen as a daunting task by many investors. There is more to mere assessment of past returns in the process of selecting winning mutual funds. It is noteworthy that it also involves analysis of factors such as performance of peers in the category, performance of the fund under consideration across phases of market cycles, risk which the fund has exposed its investors to, risk-adjusted returns, portfolio characteristics (i.e. top-10 stock holdings, top-5 sector exposure and portfolio turnover ratio), costs of investing (i.e. expense ratio and exit load), and investment processes and systems. Moreover, one cannot rule out the fact that with vast number of schemes available confusion can mount thus making the task of selecting winning mutual funds portfolio more complex. Selecting winning mutual funds for the portfolio, makes not only tracking of the mutual fund schemes necessary but also leads to multiplicity of transactions, filling forms, and maintaining multiple account statements. Given the aforementioned intricacies involved, while holding a portfolio of winning mutual funds may appear dispiriting, investing in a good Fund of Fund (FoF) scheme offers the comfort of enjoying a diversified portfolio of winning mutual funds. A FoF offers investors an excellent and a unique investment proposition, as it is a mutual fund scheme that invests in schemes of other mutual funds (thereby taking the concept of mutual fund investing to another level).