Fund of Funds is a better fit for DIY investors

Fund of Funds is a better fit for DIY investors

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The budget had nothing much for mutual funds to talk about. But there is one provision that is likely to bring some cheer to a certain category of mutual funds—the fund of funds (FoF). FoFs are mutual fund schemes that invest in other mutual fund schemes. In other words, the scheme does not hold shares or bonds of companies but instead holds units of other mutual fund schemes or exchange traded funds (ETF). The tax benefit proposed in the budget is for one small segment of the FoF universe. It has provided for FoFs that invest 95% of its assets in equity ETFs to be treated as equity funds for the purpose of calculation of short-term capital gains (STCG) tax. In February 2018, the tax treatment of long-term capital gains (LTCG) from FoFs that invested in equity ETFs was brought on par with equity funds. With the proposed change, these FoFs will now get the benefit of STCG being taxed at 15% and LTCG in excess of 1 lakh being taxed at 10%. Other FoFs, which invest in units of mutual fund schemes—whether equity or debt, or gold ETFs—will be taxed in line with the provisions for debt funds.

The special status to FoFs that invest in units of equity ETFsseem to be a way to give a leg-up to ETFs that have been used by the government as a vehicle to further its disinvestment targets. The primary disadvantage of the ETF structure, despite it being a lower cost option as compared to a mutual fund, is that it requires a demat account into which the ETF units are credited at the time of investment. Selling the units, too, have to be done through a stock exchange, which again requires a broking account. These operational issues have affected the popularity of the ETFs, and the FoF is the mutual fund industry’s way of making things easier for the investor. The investor buys units of the FoF just like any other mutual fund scheme and the FoF in turn will invest in the units of the ETF. “The FoF helps take the scheme to retail investors of ‘Bharat’ without the need for a demat account.” said Chintan Haria, head-product development and strategy at ICICI Prudential Mutual Fund, referring to the ICICI Prudential Bharat 22 FoF that invests in the Bharat 22 ETF.

In the Indian context, FoFs are primarily being used to facilitate investments into ETFs, including those that invest in gold and equity indices. They also provide a way to participate in international markets where the FoF hold units of international funds, which in turn invest in global companies. FoFs are also becoming a popular way to provide investors with an easy asset allocation product where the FoF invests in units of equity, debt and gold schemes in a defined proportion. Apart from the tax benefit in the budget, the FoFs that are still taxed as debt funds have been indirect beneficiaries too with the imposition of the 10% tax on LTCG from equity mutual funds. “The gap between the equity and debt long term capital gains taxation has narrowed. Hence, we may see more FoF offerings both in the equity space as well as the asset allocation space,” said Haria. Reliance Mutual Fund has filed a draft offer document with Sebi for an asset allocation fund that will invest in equity, debt and gold. Multi-manager FoF schemes, where the fund manager has the flexibility to select schemes across mutual fund houses, offer investors a well-diversified product. “As a risk management strategy, we allocate about one-seventh of the investable corpus in each of the schemes, which are spread across different market segments and fund management styles in order to reduce fund manager risk and capitalize on market-cap cycles,” said Chirag Mehta, senior fund manager at Quantum Mutual Fund that manages Quantum Equity Fund of Fund, a multi-manager equity scheme.

The FoF structure implies costs to the investor at two levels—one charged by the FoF and the other charged by the underlying ETF or mutual fund scheme. This has been perceived as a disadvantage to investors in FoFs. Sebi has addressed this issue by capping the total expense ratio that an FoF can charge, including the weighted average of the total expense ratio levied by the underlying scheme(s) at 2%. Most FoFs keep the expense ratio at around 1.5% or lower.

The FoF as a product seems perfect for an investor looking to separate the wheat from the chaff, given the plethora of funds types to choose from. But here a professional fund manager does the job of selection, monitoring and rebalancing in a more efficient way. While selecting schemes, the fund manager is better able to track duplication of stocks and sectors across schemes. “Since capital gains would be taxed on each switch from one scheme to another, you will have less capital being reinvested and compounding every time you switch schemes. The eventual impact of this on your corpus would be quite large. However, when the equity FoF exits an underperforming scheme and buys into a better performing one, mutual funds being pass through vehicles, it isn’t liable to pay any tax on the gains, thus keeping your capital intact for reinvestment,” said Mehta, pointing out to the tax efficiency built into the structure. But there are caveats, too, that investors have to keep in mind. All the schemes that are included in the portfolio must match the risk and return preference of the investor. A compromise on any of the schemes may lead to a situation of the fund being too risky or very low on returns. The costs are another aspect to be closely watched; both the FoFs as well as the underlying schemes have to be disclosed under the regulations. The Quantum Equity FoF, for example, has an expense ratio of 0.51% under its direct plan and inclusive of the underlying schemes, it stands at 1.51%. Frequent switching of underlying schemes and the investor’s comfort with that strategy is another fund behaviour that needs scrutiny. Investors who work with advisors may not find much use for this product. But for investors who are looking to build their own long-term portfolio, there may be some merit in considering these structures.