Fund of funds (FOFs) are yet to become truly popular in the Indian context. But across the US, Asia and Europe the FOFs are quite popular. What exactly are FOFs? Essentially, a mutual fund collects money from investor and then reinvests the same in stocks and bonds. The Fund of Funds (FOF), instead, invests the money in other mutual funds and thus the name FOF. In other countries FOFs are a very strong method of financial advise where in advisors suggest the right FOFs to individual investors and to institutions based on their risk/return/liquidity framework. In the Indian context there are two kinds of FOFs that are popular. Let us look at the two popular FOFs in India
Allocation FOFs and International FOFs
Let us look at international FOFs first. This is normally offered by the Indian funds that have foreign affiliations. For example, the DSP Blackrock used to offer an international structured as a FOF that used to invest in global Blackrock Funds. Since Blackrock is the largest fund in the world with an AUM in excess of $6 trillion, it has an exposure to virtually every market in the world. It becomes much easier for DSP to package these funds and offer them as FOF to Indian investors. It not only permits domestic investors to participate in international markets but also gives them the benefit of international diversification.
Allocation FOFs is a slightly different ball game. For example, if a mutual fund is offering a retirement fund or child’s education fund then it entails a mixture of equity, debt and liquid assets. What the FOF effectively does in these cases is to combine equity funds, debt funds and liquid funds of the same AMC in appropriate proportions to enable the investor to meet her goals. There are two distinct advantages here for the investor. Firstly, since the investor holds only one fund, there is only single NAV to worry about and track. Secondly, an allocation plan calls for constant shifts between equity and debt. If the investor does these shifts then there are tax implications on each occasion. However, the FOF being a pass-through mutual fund is not liable to pay tax on the churning. This is beneficial to the investor looking at long-term goals.
What are the benefits of FOF from an investor’s perspective?
Here are some key advantages of FOF as an investment option
- For an investor, it offers tax efficiency as the churning is done by the fund and therefore the investor is not liable to pay tax and churning becomes more efficient.
- The FOF captures multiple needs and goals of the investor under one single NAV. This simplifies the task for the investor as they do not have multiple funds and NAVs to worry about.
- The FOF is very useful if you are an investor with limited capital. On your own, you will not be able to allocate funds to equity, debt, and liquidity. Similarly, you may not have the funds or the wherewithal to invest in global assets and global commodities. A FOF can help you overcome these problems.
- A FOF is a professional service and the fund managers bring in not only their asset selection skills but also their asset allocation skills to the table. The investor in FOF is not only able to earn better returns but is also able to peg these FOFs to longer-term goals and also effectively monitor them.
But FOFs have certain disadvantages too
The FOF structure is quite complex and that makes the product slightly unwieldy. There are 3 challenges to the entire idea of FOFs in India:
- The FOF leads to duplication of expense ratios. For example, if you are looking at an international fund, then there is the cost of managing the international fund that is expensed to you. Additionally, the cost of managing the Indian FOF is also expensed to you. This makes FOFs quite expensive.
- Taxation wise, the FOF as a product is inefficient. The irony is that even if you do a FOF of all equity funds then it is still considered as a non-equity fund and taxed at that rate. This has resulted in FOF being restricted to only international funds and allocation funds.
- There is a risk of over-diversification in the case of FOFs. There are too many asset classes and multiple correlation matrices. There may be either duplication of a risk of replacement of risk rather than the reduction of risk.
FOFs are a product that is yet to catch up in India. But the 10% tax on LTCG on equity funds could give a boost for FOFs.