Fund of funds (FOF) is a very big business in other developed markets like the US, Europe and Asia. However, in India, the FOF is still to take off in a big way. What exactly is a fund of funds? It is a fund that is created by a combination of other funds. What are the advantages of fund of funds and how does a fund of funds work? Effectively, in a FOF the fund manager does not buy stocks and bonds but directly purchases units of other funds. So you can create a long term planning FOF by combining equity, debt and liquid funds in the appropriate proportion. Alternatively, you can create a FOF of global funds which can help to diversify your domestic risk.
If you consider the fund of funds example of India, the AUM of FOFs is just about 1% of the total AUM which makes it extremely small by global standards. The advantage of the FOF is that in bad markets it tends to lose less as its performance is closer to the average performance. That is also the shortcoming of the FOF in good markets when FOFs typically tend to underperform other funds. That is the reason FOFs have really not taken off in a big way. Here are five things you need to know about investing in FOFs.
1. FOFs work best in case of allocation funds
The concept of FOF works best in case of allocation funds. What do we understand by allocation funds? When you are planning your long term goals, you need to create a portfolio that is a mix of equity, debt, gold and liquid funds. The beauty of FOF is that it helps you to combine these asset classes directly through an FOF with a similar risk and return profile. You just invest in a single FOF with a single NAV and your long term goals are taken care of. Also, in case of FOFs, the fund manager has the advantage of opting for a dynamic approach where the asset mix can be tweaked. From an asset allocation point of view, FOFs can really make a lot of difference.
2. FOFs have an advantage when it comes to global exposure funds
Another key area where FOFs can make a difference is in the area of international funds. Typically, fund houses like DSP Blackrock and Franklin Templeton with international affiliations have offered international funds structured as FOFs. The way these FOFs work is that the Indian arm of the fund uses the AUM of the international fund to invest in the units of the international fund based in the US or Europe or even pegged to commodities or to the price of international gold. This is a low cost method of participating in international assets and also diversifying domestic macro risk.
3. Diversification with much lower capital
This is a unique advantage that FOFs offer. As an equity investor or as a mutual fund investor, there is only so much diversification that is possible with limited capital. FOF actually overcomes that problem. With a small investment of Rs.5,000/- an investor can get access to equities, debt, liquid funds, gold, commodities, international indices and almost every conceivable asset class that is available. Normally, international diversification helps you to reduce your macro risks to a large extent. For example, in the last one year when the Nifty and the Sensex have been extremely volatile, the US markets have done very well. So, a FOF that has exposure to US indices like DJIA and NASDAQ, would have outperformed most Indian equity funds. That is why diversification is important from the point of view of risk and returns.
4. Convenient but expense ratios can be high
Of course, FOFs are convenient because you are able to reach multiple goals with a single product. Also, it is convenient as there is a single NAV for you to track. Compare that to a financial plan where you create your own combination of equity funds, debt funds and liquid funds. There are multiple fund portfolios to monitor and multiple NAVs to track. The downside is that these FOFs also become expensive. There is the cost of managing the fund and then there is the cost of managing the FOF. When these costs are added up the total expense ratio (TER) becomes quite high. That is why FOF works better when the underlying are low-cost index funds or when you are targeting asset allocation for the very long term.
5. Tax-wise FOFs are fairly inefficient
Over the last few years, the mutual fund industry has been consistently lobbying for a more favourable tax status. There is a taxation anomaly with respect to FOFs. For example, even if your FOF is a fund of equity funds, for tax purposes it will still be considered a non-equity fund. That means short term will be 3 years and STCG will be taxed at the peak rate. Similarly, LTCG will be taxed at 20% after considering the benefit of indexation. This puts the FOF at a disadvantage over equity funds. Also, the dividend distribution tax (DDT) is imposed at two levels and that also adds to the cost. The unfavourable tax treatment is one of the key reasons why the FOFs have not taken off in a big way in India.