Investing in fund of funds

When markets behave like they have in 2011, the one who loses less is called a winner. Fund of Funds by their very design are meant to lose less. Still, only 1 per cent of the Indian mutual fund industry's AUMs are made up of Fund of Funds (FoF). One would think there must be a good reason for it. Actually, allow me to give you three. But first, what is a FoF?

At its simplest - a mutual fund that invests in other funds is a fund of funds. Conceptually it does what you do, create a portfolio of funds. The difference being, when you buy funds yourself, you buy them individually and hold and track them separately, while when you buy a fund of funds, you hold just one fund which in turn holds other mutual funds inside it.

Coming back to the reasons; first is plain boring mathematics. Because it holds many funds in it, a fund of funds will not deliver performance equal to or better than the single best performing fund that it has invested in. The return of a fund of funds will always be closer to the weighted average returns of the funds it has invested in, quite like the return of your own portfolio of funds.

And by the very same logic, a FoF will not go down as much as the worst performing fund it holds inside it. For this very reason, fund of funds are known to give superior risk adjusted returns.

Secondly, FoF until very recently were perceived as competition by distributors. If one single fund of funds itself can buy, hold, sell, over-weight, under-weight the funds it invests in, then how will a distributor add value to the investor. This misplaced perception has begun changing in the last one year. FoF AUMs have more than doubled in the last 15 months to over R 8,000 crore as of Oct'11.

Thirdly, the larger share of fund of funds currently available in India actually invest in funds of only their own fund house. This limits the diversification benefits an investor aims for when he himself buys mutual funds from different fund houses. Globally, several fund of funds pick the best of breed funds from across different fund houses and put them together into one. These are called Multi Manager fund of funds. It's like putting together the best cricket players from across the world into one team.

Fund of funds bring several advantages too. Briefly, it's a great way to start investing into mutual funds for a first time investor. No need to worry on how to pick, retain or change a fund. If you are an SIP investor, just a Rs 1,000 SIP could actually give you access to 4-5 best of breed managers in one funds of funds Vs you having to take out Rs 1,000 minimum subscription for every manager you will invest in separately by yourself.

And for those who already hold too many funds and see managing them a hassle, they too can simplify and consolidate their holdings through a fund of funds, as long as they can find one that is similar in objectives to the funds they hold. And the good news is that options do exist.

Amongst the least known but significant advantages of a fund of funds is the short term capital gains tax that you can save. If I assume that you do change some if not all the funds you hold at least once within the first 12 months of investing in them, the gains you make on them become taxable.

However, when a fund of funds manager changes any fund it has invested in, there is no tax liability that 

accrues on to you.

Now if you combine all of the above benefits, it becomes easier to appreciate the rapid growth of FoF in India recently. FoF are now available here for single asset classes and for multiple asset classes too. Globally, fund of funds are often preferred by super HNIs for just two reasons - their superior risk adjusted returns and equally importantly, their convenience.

Source: http://www.indianexpress.com/news/investing-in-fund-of-funds/897338/0