Investor-Friendly FOFs Needed

Hemant Rustagi

CEO, Wiseinvest Advisors

While FOFs are one of the best options for investing in mutual funds and are quite popular globally, they need to be made more investor-friendly in India, says Hemant Rustagi

Mutual funds are known for being one of the most versatile investment vehicles as they offer a number of advantages to investors. One of the major advantages is the wide variety of funds they offer, thus providing investors the opportunity to not only achieve multiple goals over different time horizons but also create the right balance between risk and reward.

For instance, someone who wants to invest in equity funds, has options like Large-Cap, Mid-Cap, Multi-Cap, thematic, sector and opportunities funds. For those who may like to have a hybrid portfolio with higher allocation to equity, there are equity-oriented balanced funds too.

Similarly, on the debt side, there are options like ultra short-term, short-term, income and debt-oriented hybrid funds. In fact, investors also have the option of investing in income funds following different investment strategies. While on the one hand there are funds that dynamically change their allocation and maturity, on the other hand there are funds that follow either the accrual or duration strategy.

As is evident, mutual funds have a lot to offer through an array of market-oriented products. However, considering that there are hundreds of products to choose from, it can be a daunting task for investors to make the right selection. It is therefore often said that although mutual funds are a simple investment vehicle, investing in them is not always simple as it can be quite challenging to have the right mix of funds in the portfolio.

In this context, Fund of Funds (FOFs) can be an ideal option as they allow investors to invest in schemes relating to different asset classes through a single investment. Besides, they can do so by investing a much lower amount than if they were to invest in these schemes directly. Moreover, since many FOFs have pre-decided asset allocation, investors do not have to worry about rebalancing the portfolio, which is a key to investment success in the long run.

The Indian mutual fund industry offers three types of FOFs. First, there are funds that invest in the schemes of the same mutual fund. In this category, the most popular ones are gold funds that invest in Gold ETFs (GETFs) of the same mutual fund. These funds allow investors to participate in GETFs without having a demat account and also invest through SIPs on a regular basis. Besides, there are funds that follow the asset allocation model through a mix of funds investing in different asset classes.
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Second, there are FOFs that invest in schemes of different mutual funds. These funds allow investors to benefit from the expertise of different fund houses. Lastly, there are FOFs that invest in international funds, thereby allowing Indian investors to invest abroad and achieve a higher level of diversification. In this category, there are country-specific funds and thematic funds focusing on commodities as well as emerging markets.

Considering the benefits of FOFs as a category, they can be quite useful for investors in different segments. However, despite the fact that FOFs are quite popular globally, they have failed to make an impact on Indian investors. There are a few factors that have contributed to their muted growth here.

First, most FOFs on offer provide investors an option to invest in the funds belonging to the same fund house. In other words, investors have to depend on the expertise of fund managers belonging to the same fund house, thereby limiting their options. Also, an investor in an FOF has to bear the expenses relating to the FOF as well as the underlying funds. However, it is important to note that the SEBI has ensured that the combined expenses for the feeder fund as well as the target fund do not exceed 2.5 per cent.

Another major drawback of FOFs is their tax treatment. For tax purposes, FOFs are treated as debt funds. Hence, even those funds which have an asset allocation that may otherwise qualify for tax benefits applicable to equity and equity-oriented funds are treated as debt funds. Thus, FOFs are liable to pay a Dividend Distribution Tax (DDT) and investors too have to pay long-term capital gains tax at a rate of 10 per cent. Besides, short-term capital gains are taxed at a nominal rate applicable to investors.

Considering that most retail investors tend to be passive in nature and also need help in asset allocation, it is time to recognise the benefits of FOFs and amend the tax treatment to make them more attractive. This step alone can go a long way in making them more effective and popular. The availability of more funds investing in schemes of different fund houses can also enhance their popularity.