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How effectively can an investor use Fund of Funds (FOF)
05 Jan 2023

Fund of Funds (FOFs) are a fairly new concept in India. There are a variety of FOFs in India which are predominantly international funds launched by domestic AMCs with a foreign parent. So this is a typical FOF where the domestic fund invests in the funds of the parent and gives you an exposure to US stocks. Similarly there are commodities FOFs where you can combine equities and commodities and reduces your overall risk. How exactly does a fund of funds work and what are the advantages of fund of funds for an investor? More importantly, how to structure a fund of funds? Here are a few ways by which you can benefit from a fund of funds (FOFs)..

You can participate in global markets via FOFs
This is the easiest and most fundamental option available to you. You are substantially exposed to the Indian market and are worried that if there is a downturn in the Indian market then your fund performance can get negatively impacted. You can diversify your risk by opting for international FOFs. These can help you benefit from an upturn in global markets. For example, the US is expected to grow faster after the tax cuts are implemented. Similarly, EU and Japan have started to grow at a much faster rate. You can use the FOF route to participate in these global markets. They are passive investments and you do not need to worry about monitoring them too closely.

You can diversify your risk across asset classes
That is perhaps the most important benefit of a FOF. There are FOFs you can invest that are dedicated to commodities like gold, silver and other asset classes. This helps you to participate in the commodity up cycle and also de-risk your portfolio risk which is predominantly tilted towards equities. There are FOFs which invest predominantly in commodity indices so you do not take the specific commodity risk but you can invest in themes like ferrous metals, non-ferrous metals, precious metals, energy etc.

FOFs can become an important tool for financial planning
In more matured markets, FOFs are a very important tool of financial planning. Essentially financial planning is about achieving your goals through intelligent asset allocation. But what do you do if you are not able to get your appropriate mix. That is where FOFs can come in handy. In fact, in other countries there are advisors who purely specialize in combining FOFs to give you the risk-return matrix that is suited to your unique requirements. In India, financial advisors still rely on mutual funds and insurance to meet most of your needs. Adding FOFs to that list can help the advisors to choose from a much wider palate of products.

FOF fees normally do not add too much to your overall cost
Most FOFs are specifically designed to keep your cost as low as possible. To make them competitive, FOFs charge very low fees and this makes them competitive as an asset class. While FOFs in India are yet to mature to that level of sophistication, once FOFs become more rampant in India, the relevant costs are also expected to come down proportionately. Globally, the low fee structure of FOFs is their biggest advantage and this adds to their allure for financial planners. Once this trend catches up in India also, they could become more critical and meaningful as a tool for financial planning and asset allocation.

Getting the better of long-only funds using FOFs
Most of the equity funds in India are purely long-only funds. As a result, during market downturns, these equity funds tend to give negative returns like the index. We saw that in 2001 and again in 2008 and 2011 when most of the equity funds were giving negative returns. That is where FOFs can be extremely useful as they can handle multiple asset classes and therefore by shifting your portfolio you can manage to shift to assets that can protect your portfolio in difficult markets.

What you need to watch out for when it comes to FOFs
The big disadvantage of an FOF in the Indian context is the tax treatment. For example, a FOF is treated as a non-equity fund even if it is a fund of equity funds. That is a big anomaly and the fund industry has been trying to reason with the IT authorities to change that. That means FOFs will be treated as short term gains if held for less than 3 years and long term gains only beyond that. In case of FOFs, the STCG is payable at your peak tax rate and the LTCG is payable at 20% after indexation. Unless this anomaly is rectified, FOFs may not really attract the attention of investors and financial planners in India. Probably, Budget 2018 can be used as a platform to address this issue!

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