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What are fund of funds? Detailed guideline & analysis of investing in fund of funds in India

Fund of Funds

Funds of Funds are a type of mutual fund investing in other mutual fund schemes. It is also known as a multi-manager investment. Instead of directly investing in stocks or bonds or other securities, a fund manager makes a portfolio of mutual funds. The underlying fund for FOFs is either from the same fund house or other fund houses. 

Funds of funds aim to achieve sound diversification and appropriate asset allocation by investing in a variety of funds across different categories. This category of funds attracts small investors with low-risk appetite and also with access to a range of different asset classes. Thus these funds aim to ensure lower volatility of funds and aggressive returns for its investors. 

FOFs are actively managed, and they undergo frequent reallocation of underlying funds to stay up to date with market fluctuations. They offer tax-friendly rebalancing of the portfolio. The FOFs offered in India belong to the same fund house. In the instances where investment is made in unaffiliated mutual funds (FOF investing in a different fund house), it attracts a higher cost versus the investment made from a related specialist. It is primarily because of the additional cost for investment management research.

Funds of Funds in India

With a wide range of Funds of Funds available in the market, the following FOFs are the ones that are in demand:

  • Asset Allocation Funds: These funds invest in a variety of asset classes, ranging from equity to debt to others such as commodities, gold, and other metals.
  • International Funds of Funds: These FOFs invest in mutual funds that have exposure to shares and bonds of global companies. 
  • Gold Funds: These FOFs invest in physical gold or in stocks of companies that are into gold mining.
  • Multi-Manager Funds of Funds: These have multiple funds that are professionally managed in one single portfolio. 

Taxation

Though FOFs invest in equity mutual funds, their taxation is similar to that of a debt fund. Only upon redeeming their investment from the FOF the investor is taxed. The investor is not obligated to pay tax when the fund is actively managed by the fund manager, where he is frequently buying and selling the units of an underlying mutual fund. 

FOFs also attract Dividend Distribution Tax when invested in equity securities of domestic companies. There is a dual levy of DDT for these FOFs. The dual DDT is when the companies distribute dividends to its shareholders and again when the FOF distributes it to its unit holders.

Fund Type Holding Period for Long Term Short Term Long Term
Equity Fund 1 year 15% 10% – If gains exceed Rs. 1 lakh in a year
Aggressive Hybrid Equity Fund 1 year 15% 10%
Other Hybrid Funds If more than 65% of assets in equity, same as equity funds. Otherwise the same as debt funds. If more than 65% of assets in equity, same as equity funds. Otherwise the same as debt funds. If more than 65% of assets in equity, same as equity funds. Otherwise the same as debt funds.
Debt Fund 3 years IT Slab rate 20% with indexation
International Funds 3 years IT Slab rate 20% with indexation

Fees and Charges

FOFs have a higher expense ratio. FOFs charge management fees on the service rendered for asset allocation. Compared to a regular fund, this fee is nominally high. The annual report of the fund clearly states all the applicable charges incurred during the operation of the fund. While investing, it’s quite essential to take into consideration the total expense, as it has a direct impact on the returns on investment. 

Advantages

  • Convenience: Since FOFs invest in other mutual funds, tracking their NAV is easy since it’s just one folio. Managing and reviewing them is a lot easier compared to multiple individual funds. 
  • Rebalancing: When a FOF is rebalanced to stay up with the market fluctuations or maintain the debt-equity ratio, this transaction won’t attract any capital gains tax. Therefore, rebalancing the assets in the fund internally is tax-free. 
  • Small Investors: FOFs are best suited for investors having low capital available for investing. These funds allow them to invest in multiple funds at a time, which otherwise would have been an expensive affair to invest individually. 
  • Fund Manager and Management Services: FOFs require a manager with excellent experience and track record; this assures that a credible person maintains the funds. FOFs offer professional management services, where it provides investors with a fund that is backed by research. 

Disadvantages

  • High Expense Ratio: Similar to other funds schemes, FOFs too incur expenses. However, these expenses are higher compared to a mutual fund. In addition to the administrative and management fee, there are expenses related to the underlying funds. Though the expense ratio for FOF is 1%, the investor is obligated to pay this amount on every fund that the FOF owns. 
  • Diversification: As FOFs invest in multiple funds, there is a high probability that these underlying funds are investing in similar stocks and securities. Hence this might reduce the diversification opportunity. Unless there is a balance in the holdings, diversification wouldn’t add value to the investment. Therefore, frequent vigilance is required to hold the balance. Otherwise, the FOF will have too much exposure to the same assets. 
  • Tax Implications: In the Debt and International funds category, the STCG tax would be applied according to the investor’s income tax slab if it were redeemed before three years. For units sold after three years, LTCG tax of 20% with indexation is applicable. While for Equity funds, STCG tax at 15% for less than one year and LTCG at 10% for gains above INR 1,00,000. 

Funds of Funds investing in ETFs

FOFs allows its investors to invest in ETFs. An ETF is a portfolio that matches the composition of an Index in the same proportion. ETFs are traded on the stock exchange, unlike other mutual funds. Therefore, investors are required to have a Demat account to invest in ETFs. Ergo, to address this issue, fund houses have introduced FOFs with ETFs. This has opened the opportunity for all investors to invest in ETFs. 

Things to consider as an investor

Majorly FOFs provide a good diversification for an investor with a single fund. However, it is always advised to weigh the pros and cons before investing. Firstly, evaluate the fund manager’s efficiency, pick a fund with the most experienced manager. Secondly, ensure that your investment objective is in line with that of the fund. Thirdly, based on your risk appetite, investment horizon, and tax implications, choose the fund that best matches your profile. And lastly, consider the high expense ratio of these funds. 

Published on February 10, 2020