Fund of funds (FoFs), as the name suggests, are mutual fund schemes, which invest in other mutual fund schemes. There have been a few such FoF schemes in the past and recently too some new FoFs have been launched.

Does it make sense to invest in FoFs? Let us look at the various issues associated with FoFs -- some are positive and some negative.

Diversification (+ve)

Just as a mutual fund scheme offers diversification by investing in various equity scrips, a FoF offers diversification by investing in various MF schemes. Experience of the past few years shows that the top performers are usually different from year to year. However, there are certain funds, which have been consistent performers.

Therefore, a FoF that invests say in 4-5 of the top ten funds today, is expected to yield better returns than say investing in the top performing fund of the day.

Secondly, you get a chance to diversify across various fund managers and investing styles.

Thirdly, even if a fund manager quits one AMC and joins another whose fund you already own in the FoF, you are not affected by this constant movement of the fund managers.

Convenience (+ve)

As a prudent investor, one would like to diversify one's investment across both equity and debt funds. By choosing a suitable FoF, you get a chance to invest across different class of funds with just one investment. Thus, it becomes very convenient for investing and monitoring.

Also, suppose you wanted to invest in 5 equity funds and 5 debt funds. Assuming each fund has a minimum stipulated investment of Rs 5,000, you would need Rs 50,000. In a FoF, Rs 5,000 would do the job.

Rebalancing (+ve)

This is a great benefit that a FoF offers - in fact 2 benefits as we see later.

Suppose you have Rs 100 to invest and your debt-equity allocation is 30:70. After one year the Rs 30 in debt has grown to say Rs 32.40 @8% p.a. and the Rs 70 in equity to Rs 94.50 @35% p.a. The debt-equity allocation has now become 25.5:74.5.

Thus the portfolio has become riskier than your profile of 30:70. Therefore, you need to sell Rs 5.67 of equity and put in debt to bring back the debt-equity ratio to 30:70.

Conversely, say after one year the debt had grown to Rs 32.40 @8% p.a., but equity portion suffered a loss of 20% and reduced to Rs 56. The debt-equity ratio changed to 36.7:63.3. Now you need to sell Rs 5.88 from debt and put into equity.

This rebalancing will involve capital gains tax, if you do it by holding individual MFs. When a FoF does it, there is no long/short term capital gains tax, which can be as high as 30% on short-term capital gains in a debt-fund. This is a big benefit.

The second benefit that FoF rebalancing offers is a psychological one. Usually people don't sell when the markets are rising and don't buy when the markets are falling. Yet this is exactly what one should be doing. FoF does it automatically (and it usually can be in your long term interest).

Higher costs (-ve)

A FoF charges 0.75% annual management fees. This will be over and above the annual management fees of the MF schemes it will invest in, which are typically 2.5% for an equity MF and 1.5% for a debt MF.

Thus the effective cost for you works out to around 3.25% and 2.25% for equity & debt MF respectively.

Single AMC FoFs (-ve)

Most FoFs were, till recently, not true FoFs. They invested only in the different funds of the same AMC, which promoted the FoF. Only recently, some FoFs have been launched which will invest across different AMCs and hence will be truly diversified.

Higher Tax (-ve)

As per the present tax laws, equity FoF does not enjoy the benefits available to a normal equity fund. Therefore, if one invested in an equity FoF he would be liable to pay dividend distribution tax of 14.03% or LTCG tax of 10% (without indexation), which is otherwise NIL for a normal equity MF.

This higher tax can significantly reduce the post-tax returns.

Since the advantages and disadvantages are quite varied, the investors would have to assess their individual situation in the light of these factors and then take a decision as to whether FoF suits them or not.

Also, one should check the costs and the close-ended nature (thus not giving an investor a chance to do SIP), when investing in new FoFs.

The author is an investment advisor and can be reached at sanjay.matai@moneycontrol.com.

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