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Why You Should Consider Investing In Fund-of-Funds - Outside View by PersonalFN

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Why You Should Consider Investing In Fund-of-Funds
Aug 30, 2017

Due to the lack of financial literacy, retail investors often end up making costly investment mistakes. Without proper handholding, investors may save too little, churn their portfolio frequently, buy high and sell low, invest in fad products, and make the wrong choices.

The mutual fund industry does not make it any easier either. There are over 400 equity mutual funds, and according to the studies done by our research team, as high as 32% of the mutual funds are not worth your investment.

To select the right mutual fund, you may consider the following:

  1. Do your own research. This may be time consuming and you will need access to consolidated data that is available for a fee. If you thought mutual fund star ratings will make your job easier, you're mistaken. A single scheme may have different ratings across research agencies, as we highlighted here. This makes your search even more difficult. Even if you do spend the time to pick the right funds, you will need to regularly invest more time to monitor the portfolio and make changes if necessary.
  2. Opt for unbiased research services There are mutual fund research services available for a subscription. Here, choose one that is entirely unbiased. Make sure, they have an expansive track record for picking best mutual funds for you. A rigorous research methodology considers both quantitative and qualitative parameters when ranking funds, and is critical to make a prudent choice.
  3. Hire an investment adviser. This is a good option. However, you need to choose wisely. Some may lack the research experience, while others may not be entirely biased. Some may adopt unethical practices, promoting funds through which they indirectly earn them better commissions. Hence, you need to choose an investment adviser you puts your interest before his own.
  4. Invest in a fund-of-funds. Fund-of-funds (FoFs) offers you, the investor a unique and excellent investment proposition. Instead of picking stocks, these mutual fund schemes invest in the schemes of their own fund house or a third party fund house. A FoF manager specialises in selecting the right mutual fund scheme for the fund, and he makes the decision of investing or redeeming a scheme. Investors get a portfolio of some of the best mutual fund schemes in the industry

While you may be aware of the first three routes of picking mutual fund schemes, the last one is lesser known. Though this is an attractive investment proposition, FoF schemes are rarely talked about. However, such schemes can add immense value to your portfolio.

Those aware of FOFs may be apprehensive of investing in such schemes for more reasons than one. That's because FoFs are classified as non-equity schemes, and that makes the returns liable for tax, if held on for over a year. Though there are other reasons that discourage most investors from taking FoFs seriously, however, this has little implications on the long-term potential of these funds.

PersonalFN highlights some of these reasons and myths stopping investors, and why in reality these are minor implications. Investors need to look at the bigger picture.

  • FoFs charge double expenses

    Many may cite that in addition to the expenses charged by the underlying schemes, FoFs charge an additional fee. Well, it is true that FoFs do charge an additional fee, but it is to defray the fund management costs and other expenses incurred. However, this fee is considerably low. Most FoFs charges an annualised fee of under 1.5% for the regular plan and under 1% for the direct plan. For some schemes, the fee is as low as 0.5%.

    In addition to this, the underlying portfolio of the fund in most cases consists of direct plans. Hence, the overall costs are low.

    FoFs cannot charge investors as per their whims and fancies. As per Regulation 52(6) of the Mutual Funds Regulations,1996, the total expenses of a FoF including the weighted average of charges levied by the underlying schemes shall not exceed 2.50% of the daily net assets of the scheme. Hence, the overall costs could be lower than certain equity mutual funds as well.
  • FoFs attract a tax liability

    As mentioned earlier, FoFs are classified as non-equity schemes, and hence they do not enjoy the tax benefits of equity-oriented schemes. For FoF schemes, STCG for units held for less than 36 months, is added to the total income and taxed accordingly. LTCG attracts a tax of 20% with indexation.

    Equity schemes on the other hand attract Short-term Capital Gains (STCG) tax of 15%, while Long-term Capital Gains (LTCG) is tax free. The holding period is one year to be considered as LTCG.

    Clearly, the tax liability will eat into the returns of a FoF scheme. However, investors tend to overlook the fact that a FoF scheme has the potential to deliver far superior returns than most equity schemes. Hence, even if the post-tax returns are considered, FoFs could still outperform, as the scheme selection is backed by a robust research methodology.
  • Biased to in-house schemes
    Fund houses assumed to pick schemes that are managed by them for FoFs. However, this may not be the case, unless specified in the investment allocation specified under Section II of the Scheme Information Document (SID).

    The fund managers are expected to adopt an unbiased approach to pick funds that are not limited to their own fund house or a specific fund company. The scheme selection in most cases is driven by a comprehensive research methodology and market outlook.

If the above reasons are holding you back from investing in a FoF scheme, it is time to reconsider. Below we take a look at the post-tax performance of a few Fund of Fund schemes versus the S&P BSE 200 index and category average of equity diversified schemes over 3-year and 5-year periods.

How have FoF schemes fared?
FoF Scheme3 year (%)5 year (%)SD Sharpe
Quantum Equity FoF Fund(G)14.0517.6913.520.18
Birla SL Asset Allocator Multi FoF(G)13.3514.528.570.26
ICICI Pru Very Aggressive(G)13.3012.815.950.33
Kotak Asset Allocator Fund(G)10.7215.286.310.21
IDFC Asset Alloc-Aggr-Reg(G)10.5311.597.490.16
Equity Diversified Schemes    
Average of 105 schemes14.4118.0815.040.17
Benchmark    
S&P BSE 20011.8515.4513.700.09
Data as on August 4, 2017,
*Returns of FoF scheme is post-tax; Standard Deviation and Sharpe are calculated over 3-Yr period assuming a risk-free rate of 7.38% p.a.
(Source: ACE MF, PersonalFN Research)

Clearly, some FoF schemes have outperformed the benchmark by a good margin. These schemes do well in terms of managing risk and deliver superior risk-adjusted returns. Opt for a scheme that has performed consistently and that has a proven track-record of selecting winning mutual funds.

To summarise, we highlight the benefits of a FoF scheme below:

  • Investors do not need to spend time doing their own research and let the fund manager do the job for them.
  • You have an opportunity to invest in a bouquet of the potentially best performing funds.
  • Proven research process and risk control measures that are essential for making investment in any mutual fund schemes tend to work in favour
  • You reap the benefit of diversification across mutual fund schemes as well as fund management styles
  • You get a readymade portfolio to deal with the current market conditions.
  • Certain fund houses, offer FoFs based on the investors risk profile. Hence, conservative FoF portfolios will give a high weightage to debt mutual funds, while aggressive FoF portfolios will have a higher allocation to equity funds. You can choose a fund as per your risk profile
  • FoF will aid you to consolidate your mutual fund holdings. Hence, instead of holding multiple funds, you can hold a single FoF

One such FoF scheme that offers promising long-term returns is Quantum Equity Fund of Funds. Quantum Equity Fund of Funds follows a comprehensive research methodology, developed by PersonalFN, for selecting the schemes. The research methodology comprises a nice blend of a quantitative and qualitative analysis. It is the only scheme that exclusively invests in third party mutual funds, ensuring there is no conflict of interest. Hence, investors who are looking forward to investing in well-managed and established mutual fund schemes should strongly consider Quantum Equity Fund of Funds.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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