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Why investors can avoid domestic fund of funds

Why investors can avoid domestic fund of funds

05 Apr 2021

A flurry of fund of funds (FoF) have been launched in the recent past and the investor has many to choose from. However, here is what every investor should keep in mind. Since FoFs invest in other mutual fund schemes, there arises a duplication of costs. Investors have to bear the expense ratio of the original schemes as well as that of FoFs. For instance, Nippon India Asset Allocator FoF investors have to bear the expense ratio of the FoF (0.19%) and the weighted average expense ratio of its constituents—Nippon India Small Cap Fund (1.06%), Nippon India Growth Fund (1.26%) and Nippon India Large Cap Fund (1.18%). You should take the FoF route only if this additional cost is justified. Let us consider the factors that need to be taken into account while arriving at the decision.

Going global
Lack of availability of a primary scheme—a domestic mutual fund scheme—is one factor that justifies taking the FoF route. More importantly, this new scheme should fit into your portfolio profile. “Investors should check the underlying scheme and see what purpose it serves in their portfolios. It makes sense to go the FoF route for regional or sector or theme-based diversification. It will be difficult for Indian investors to bet on themes like global climate change or international Reits without the FoF route,” says Arun Gopalan, Head of Products and Research, Kredere Wealth Partners.

Why not invest directly in international stocks using the liberalised remittance scheme (LRS), you may ask. You can invest directly, but do you have the investment expertise to do that? If not, your investment experience can be painful. It is good to remember that Indian fund houses are not directly venturing into international space because of their lack of investment expertise. “Since there are several international fund managers with great expertise, it makes sense to take the FoF route instead of buying directly into global stocks,” says Harshad Chetanwala, CoFounder, MyWealthGrowth.

You can partially solve the investment expertise issue by investing in international primary funds or exchange traded funds (ETFs). However, this will create another bother—detailed reporting under the LRS regime. “Though FoF will be slightly more expensive than international primary funds or ETFs, FoFs give you the shelter of domestic mutual funds and saves you from the need of detailed reporting under the LRS regime,” says Vishal Dhawan, CEO, Plan Ahead Wealth Advisors.

FoF route also offers another advantage for HNIs. “In addition to operational ease, international FoFs can also overcome the investment cap fixed under the LRS regime,” says Vivek Rege, Founder & CEO, VR Wealth Advisors. The LRS limit right now is $2.5 lakh per annum.

Recent fund-of-funds NFOs@2x

While it makes sense to use the FoF route for global diversification, it is better to avoid very narrow or regional themes. “Unless you are an expert in a region or theme, it is better to avoid very narrow or regional themes because the risk involved will be very high. Go with broader themes like emerging market funds and not with funds dedicated to countries like China, Brazil, etc,” says Rege.

Utility less for domestic FoFs
The usefulness of FoFs reduces drastically when it comes to the domestic scenario. Some of the recent launches are FoFs that invest in their own ETFs. Value addition is low here because investors can buy the primary ETFs directly from the secondary market. However, this may be useful for a section of investors. “FoFs investing in ETFs will be useful for mutual fund investors who don’t have demat or trading accounts,” says Dhawan. Direct ETF investors also have to bear additional expenses like brokerage, demat charges, etc and this will also negate a part of the FoF expense ratio.

New launches are also happening in FoFs providing ready asset allocation based on age or risk levels like aggressive or conservative, etc. “The value add by asset allocation FoF is low because the same can easily be replicated by individual investors,” says Gopalan. It is better if investors do it themselves with the help of an adviser. “Asset allocation through FoFs may not always work in favour of investors because the asset allocation needs to be dynamic and not fixed,” says Chetanwala. Asset allocation FoFs serves the purpose of balanced funds. There is no need to take this route as several well managed balanced funds are available.

After the reintroduction of long term capital gains tax on equities, the difference in taxation between the primary fund and FoF has reduced. However, it still exists in some part and makes FoFs investing in domestic funds inefficient. While short term capital gain from equities will be taxed at 15%, it will be charged at marginal rates for FoFs. Similarly, definition of LTCG is also different—one-year holding for equity funds and three for FoFs.

(Graphic by Sadhana Saxena/ET Prime)