FUND FLAVOUR

February 2015

Fund Of Funds - High Society For The Little Guy

Buying a mutual fund is a bit like hiring someone to fix the brakes in your car. Sure, you could do the research, buy the tools and fix the car yourself (and many people do), but often it is not only easier but also safer to let an expert handle the problem. Mechanics and mutual funds may cost you a little more in fees, but there is nothing inherently wrong with paying extra for peace of mind. Mutual funds usually allow investors to skip the murky, confusing world of stock picking. But now regular investors have a way to get in on the action through fund of funds.

A smart way of investing in mutual funds

Fund of Funds offer investors a unique and excellent investment proposition. These are mutual fund schemes that invest in the schemes of other mutual funds. It takes the concept of mutual fund investing to another level. While mutual funds invest in stocks of various companies, Fund of Funds invest in the schemes of their own fund house or a third party fund house.

How does FoF work?

A fund of fund is one whose portfolio is selected from other investment funds, giving investors a double level of diversity in their portfolios. Just as fund managers for single-manager funds vary their approach to stock selection, managers of these FoFs choose the funds for their portfolio in a range of ways, with most of them using a combination of quantitative and qualitative research. Researchers will look at the ratings that funds have been awarded by reputed rating agencies; they will then delve further into the management and performance of potential portfolio members, and will often meet the managers of the single-manager funds. Funds of funds either operate with a single asset class, or as a mixed fund, such as a ‘Balanced’ fund which will invest in a range of different asset types. Mixed asset funds are particularly popular because they offer the investor a well-diversified portfolio, selected by an experienced fund manager, all within a single fund. Once investors have decided on their risk profile (sometimes categorised as Aggressive, Balanced, or Cautious) all further fund choices are left to the manager in charge of running the FoF. The manager will then monitor and manage the portfolio on behalf of the investor.

Fund of Funds can be Sector specific e.g. Real Estate FOFs, Theme specific e.g. Equity FOFs, Gold based gold ETFs, Objective specific e.g. Life Stages FOFs, Style specific e.g. Aggressive/ Cautious FOFs etc, or overseas fund of funds, which invest across the globe.

There are three types of fund of Funds:

1. Funds which invest in other domestic mutual funds. Example, FT Life stage fund of funds, Kotak Equity FoF.

2. Funds, which invest in domestic exchange-traded funds (ETFs). Examples are Reliance Gold Saving, Kotak Gold Fund, Quantum Gold Savings Fund.

3. Funds, which invest in overseas mutual funds. Examples are Fidelity International Opportunities Fund, Franklin Asian Equity Fund, Kotak Global Emerging Market Fund, BNP Paribas China-India Fund, ICICI Prudential Indo Asia Equity -Retail, Fidelity Global Real Assets Fund, DSP BlackRock World Gold Fund – Growth, etc.

Fund of Funds stand out…

If one compares mutual funds to the supermarkets of the investment world, fund of funds (FOFs) would be something of a warehouse available to the retail buyer. Fund of funds can be extremely useful as they manage expertise of different funds and fund managers. They offer an incredible amount of variety, diversification and opportunity to investors, and this has been their key attraction point in the past few years. Moreover, in India a lot of FOFs allowed asset management companies (AMCs) to invest in their international funds run by their parent or partner firm, taking portfolio diversification to an entirely different level. It is during quick surges that equity funds will outperform FOFs. However, in a negative scenario, the utility of FoFs comes into play as they are spread over several asset classes and many times several markets as well. Another type of mutual fund, which also comes under the FOF bracket, is multi-manager fund. While these funds operate on a very similar level, the basic difference is that instead of investing with different funds, the fund invests with different fund managers, giving each one some amount of money to invest with. In India, ING Investment Management has a variety of multi-manager funds under the FOF segment.

...but still a fledgling in the Indian context

While FoF is still a relatively new concept in the Indian mutual fund space, it is no doubt getting investors’ attention. Fund of funds are traditionally segmented, based on the risk an investor is willing to take. Hence, if an investor is retiring soon he should choose a conservative FOF, while someone who still has a while to go before retirement may choose a more aggressive one. The major diversification advantage of an FOF is it enables one to invest in practically hundreds and thousands of stocks, without taking the risk of a single manager having to manage such a vast portfolio. An FOF allows experts in each category to manage their funds, and hence you have essentially invested in a fund, which is not a “jack of all trades” but hopefully a master of all. When it comes to portfolio planning, the most pressing question on most investors’ minds, or fund managers’ minds for that matter, is that of right asset allocation. The most commonly accepted “don’t”, about not putting all your eggs in one basket, is an often-cited fact. However, leading questions like how many baskets should you have or how many eggs should be in any basket at any given point of time are still answers we seek. Hence, an FOF which invests in an entirely different geographical area or just gives you the option of diversifying across various funds and the stocks invested in each of them, does help in eliminating the overall portfolio risk by spreading out.

While FOFs do offer investors, especially the new ones, a chance to instantly diversify their portfolio with the least amount of analysis or paper work, things can sometimes go awry as well. One of the main contentions here is, say if an FOF through its various fund holdings ends up holding similar stocks via many of these funds, the sole advantage of their diversification offers, would end up completely back firing. This is where the fund manager’s ability to pick and choose the right funds and managers to back, whilst maintaining a constant look at their holdings, needs to come into play. But FOFs are a little more costly than the normal mutual funds. This is because the expense fee charged by the underlying funds is added to their own expense fee, making the overall product a little costlier. However, if one were to look at a mutual fund as their solution for not wanting to spend too much time picking individual stocks, an FOF saves you time and anxiety by even choosing the mutual funds worth investing in. This additional cost is almost like a premium paid for a better product. All in all, the FOF market space is still highly underdeveloped in India and the number of schemes and offers are bound to keep increasing as the market opens up. Some of the FOFs available in the market have already done well, and it will be interesting to see how the newer ones do as, for if all goes well, FOFs may well be the new way to go for both the AMCs as well as investors.

The verdict

But before you invest in a FoF, you need to check whether the investment objectives and the asset allocation followed, suits your investment objectives as well. In addition, you need to be ready to bear the high net expense fee (which is higher than regular equity oriented mutual fund schemes), as an FoF pays the fee both at its level as well as on the underlying mutual fund investment schemes in which it is invested in. 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 resources for 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

Do FoFs merit a second look?

If there is one class of products that is not fully appreciated by mutual fund investors, it is the Fund of Funds. Opinion may now be divided as to the FoF's real worth - it is probably much too early to examine that - but there is no denying that this category is here to stay. And actually prosper, if you listen closely to those who are championing its case. We know all about the common investor's penchant for stand-alone, single-manager funds. Selecting the best fund managers is not easy, as anyone faced with this diversity in the country's MF space will realise. An FoF, against this backdrop, can combine a number of single managers, each of whom may be acting differently, guided as they are by different investment mandates. That is the core of a FoF's unique selling proposition. The process paves the way for sensible asset allocation. Talking of selling propositions, investors must be told about the risks as well. To begin with, an investor needs to be aware that such a FoF will be as good as the funds it invests in. In other words, its performance will be shaped by whatever is done by these underlying schemes. Also, investments in the underlying assets will have to face such factors as performance of their portfolio, exposure to derivatives and security lending. It is important to realize that if the AMC levies an entry or exit load and the underlying funds do not waive the load charged on investments/redemptions, the investor concerned will incur load charges on two occasions. It may be pointed out that an FoF may normally provide a limited quantum of information on the underlying funds. It may not always be possible for a lay investor to access specific data, especially exact details of their portfolios. Having said all this, there is little doubt in our minds that FoFs will do better in the days ahead. One, there will be more products. Two, the performers among the current crop of FoFs will begin to attract more assets. Granted, these are still microscopic, particularly when compared to some of our giant stand-alone funds. How soon the situation will change is not for us to predict. But that change seems inevitable.