Such products claim to invest in the best of the breed, but do they make sense for the Indian investor?
21-Feb-2011 •Research Desk
China Development Bank, the state-owned lender that owns part of the UK’s Barclays Bank, is set to launch the country’s first private equity Fund of Funds (FoF). With direct approval from the State Council, China’s cabinet, the FoF is scheduled to raise a total of ¥60 billion ($9 billion), providing a huge boost to the country’s burgeoning domestic private equity sector.
A FoF is a great idea where private equity is concerned. The entry level into a private equity fund is extremely high, well beyond the reach of the retail investor. So accessing private equity through a FoF is a perfect mechanism. With relatively small individual amounts, a retail investor can buy into a FoF which will then invest efficiently by building a diversified portfolio of private equity funds.
Does the same logic apply to mutual funds?
Theoretically, very much so. Practically speaking, in India, there is not much to write home about. FoF exist in the mutual fund industry but have never really caught the fancy of investors. It made perfect investing sense during the days of entry loads when investors were charged around 2 per cent to invest in a fund. If one had to buy a FoF, all he had to do was pay the entry load for this one fund and not for all five funds to build a portfolio. However, the fund houses who do promote such schemes feel that they are as relevant today as they were earlier.
Even if such products do have a place in the portfolios of retail investors, where they have failed to live up to expectations is in terms of performance. None of them stand out in terms of fabulous returns. But then, can one expect that of such a product? A FoF is nothing but a portfolio. So in all fairness, it does not make for a straight comparison — a FoF with individual top performers. There will definitely be a difference when an entire portfolio of funds is being compared to individual options. So if one cannot compare a FoF with individual funds because of the structure of the product, then the comparison will have to be made with category averages. Even so, not all pass this test.
Besides the lukewarm performance, what we certainly do not like about a FoF is its tax treatment.
If you invest in an equity fund, you pay 15 per cent as short-term capital gains tax (if you sell your units before a year of holding). Long term capital gains is nil, a major positive for equity funds. So if you sell your units after at least a year of holding, which should be the case in equity, you pay no tax at all.
If you invest in a debt fund, the tax treatment is different. The short-term capital gain on debt funds is added to the taxable income of an individual and is taxed as per the applicable tax slab. Long-term capital gain is taxed at 11.33 per cent without indexation or 22.66 per cent with indexation.
All FoF are treated as debt funds where the tax aspect is concerned. So one might as well invest in a good performing equity fund; you pay no entry load and the tax treatment works to your benefit. A FoF will also charge you an expense ratio, this is in addition to the expense ratio already charged by each individual fund in the portfolio. So basically an extra expense is being paid. Having said that, the expense ratio for a FoF (currently at 0.75%) is much lower than an actively managed fund.
So who should look at a FoF?
The answer to that depends on the product in question. For instance, if one is talking about ING OptiMix Global Commodities, it would be attractive to any investor who wants such global exposure or exposure to a particular asset class (commodities in this case). This fund will invest primarily in the units of global mutual funds which invest in commodity related securities. The current allocation is to international funds from asset management companies such as JP Morgan, Society Generali (now Amundi), Mirae Asset and First State. Such a product can add tremendous value to one’s portfolio. Through this FoF, you can access funds you ordinarily cannot buy on your own.
If we are looking at the domestic schemes, it can be suited to anyone and everyone, though frankly, we are not that gung-ho on the schemes currently available. It does make for a good investment for someone who has very little money to invest and is on the lookout for a diversified portfolio, which he will not be able to construct with meagre monthly amounts.
Alternatively, it’s also suited for someone who probably has the money but absolutely no time to select many funds, build a portfolio and then monitor it.
However, investors should only look at schemes that invest across the mutual fund landscape in India, not those that are restricted only to their own particular fund house.