VR Logo

Diversification through Fund of Funds

Though mutual funds are diversified instruments this doesn't mean that you should invest in just one fund. A fund of funds offers the facility of investing in a number of other mutual funds.

A financial advisor will always tell you to diversify your investments across mutual funds. So, an ideal portfolio is likely to have Zurich India Equity and Franklin India Bluechip (equity funds), IDBI Principal Income Fund and JM Income Fund (debt funds). And Reliance Vision to provide the kicker to your portfolio.

Now, imagine this task is handed over to a mutual fund. A Fund of Funds (FoF) is, as the name suggests, a collection of funds. It is a financial instrument that invests in a number of mutual fund schemes. So, just as a mutual fund is a collection of stocks or bonds, a FoF is a collection of funds.

How does it benefit investors, you may ask? Well, the benefits of a FoF could be numerous. One could obtain combinations of the best performing funds of different fund houses. As a FoF would monitor the portfolio and make changes from time to time, investors would be saved from the botheration of tracking funds. More importantly, mutual fund schemes are exempt from taxes on their capital gains. This would make a FoF a very tax-friendly instrument whenever the portfolio is re-adjusted between equity and debt. As compared to this, investors have to pay capital gains tax when they redeem profits from the funds.

However, there are a few stumbling blocks in the way of introducing the FoF concept in India. At present, the Securities & Exchange Board of India (SEBI) doesn't permit investment over 5 per cent in any other mutual fund scheme from the same fund house or any other fund. Also, a management fee can't be levied on such investments. All this prevented AMCs from launching FoF schemes. But recently, SEBI decided to take a fresh look at FoFs, and has made certain recommendations. It has proposed that a FoF scheme can't invest in another FoF scheme. Likewise, a mutual fund can't invest in FoFs. As a matter of rule while FoFs will have to invest in other fund schemes, they will be allowed to maintain a small cash component for liquidity purposes.

All this may be a positive development, but there are more questions than answers. One issue is that the investor will have to bear management and administrative expenses two times, as the money is passing through two funds. SEBI proposes to cap the expense ratio of FoFs to a maximum of 0.75 per cent of total assets, including the management fee. The market regulator has also suggested keeping the total expense of FoFs and the schemes they invest in at the existing limit of maximum of 2.5 per cent. Thus, FoFs may avoid investing in a fund with high expense ratio as it may it be difficult to manage expenses within the set limit. Furthermore, there may be a vested interest for FoFs to invest in a scheme of its own fund house. This way they can earn a fee from the FoF as well as the invested fund.

So, till we find solutions to these issues, it will be difficult to conclude whether a FoF will be able to carve niche for itself. And while a FoF may solve the problem of monitoring too many fund schemes in a portfolio, what if too many FoFs are introduced?