Assess true cost: Add up expense ratio of FoF and underlying funds

Understand the risks of the underlying funds and whether their strategies match your objectives

A recent report from DSP Mutual Fund highlights the lack of transparency in how fund of funds (FoFs) disclose total expense ratios (TERs). While some disclose the expense ratio of both the wrapper and the underlying funds, others do not, making it hard for investors to gauge actual costs.  How FoFs work  An FoF invests in other mutual funds instead of directly holding stocks, bonds or other assets. “FoFs could also act as a feeder fund into another fund, such as an exchange-traded fund (ETF),” says Chirag Mehta, chief investment officer, Quantum Asset Management Company. Depending on the objective, FoFs may invest in equity, gold, international ETFs or active mutual fund schemes.  The underlying funds may belong to the same or different asset management companies (AMCs), and may be domestic or international.  Convenience and diversification  FoFs offer convenience—investors can access them without a demat account.  They also provide diversification. “FoFs allow investors to diversify across multiple asset classes and market segments through a single investment,” says Anil Ghelani, head – passive investments and products, DSP Mutual Fund. 

  FoFs help reduce the risk associated with the underperformance of any one fund by spreading exposure across asset classes, sectors, investment styles and geographies.  “FoFs enable systematic investment plans (SIPs), which are not possible in ETFs,” says Gautam Kalia, head of investment solutions and distribution, Mirae Asset Sharekhan.  Rebalancing within a diversified FoF is handled by the fund manager, which leads to tax efficiency. “Tax liability arises only when the investor sells units of the FoF,” says Ghelani.  FoFs in the income plus arbitrage category, which are not classified as equity or debt, qualify for long-term capital gains after two years and attract a tax rate of 12.5 per cent. “This gives them an advantage over debt funds, the gains from which are treated as short-term capital gains and taxed at slab rate, irrespective of the holding period,” says Atul Shinghal, founder and chief executive officer (CEO), Scripbox.  Kalia adds that FoFs are also useful when liquidity is limited in the underlying ETF.  High cost can erode returns  A key drawback of FoFs is their dual expense structure. “An FoF charges an expense ratio. This is over and above the expenses of the underlying schemes. This can lead to a marginally higher cost of investing,” says Ghelani.  Investors also cede control in these funds. “They can’t choose the underlying funds,” says Mehta.  Selection risk arises if the fund manager picks poorly performing funds. Duplication risk is another concern. “The same stocks or instruments could be held across different underlying funds,” says Shinghal.  Excessive diversification in FoFs can dilute the impact of outperforming funds.  When to invest in them  FoFs suit investors unable to access certain assets on their own. “Use an FoF to invest in global securities or in commodities without having a demat account,” says Ghelani.  Mehta adds that investors lacking the time, knowledge or access to financial advice should consider solution-oriented FoFs.  Shinghal says FoFs are also suitable for investors seeking exposure to different asset classes or geographies without spreading their investments across multiple schemes.  FoFs can offer dynamic asset allocation, managed professionally. “Such FoFs automatically adjust their exposure to different asset classes based on market conditions or a predefined model,” says Shinghal.  Kalia recommends FoFs when liquidity in underlying ETFs is low.  When to avoid them  Cost-conscious investors may prefer alternatives. “The double layer of fees in FoFs can impact returns over the long term,” says Shinghal.  Ghelani adds that those with a demat account might prefer buying ETFs directly.  DIY investors who enjoy fund selection and portfolio management can often build cheaper, tailored portfolios on their own. Investors with strong conviction about a particular theme or strategy might do better investing directly in a specialised fund rather than a broad FoF.  Key checks before investing  Understanding the FoF’s objective is crucial. “Check whether it is an asset allocation fund, a gold FoF, an international FoF or a multi-manager fund. The FoF’s strategy should align with your goals,” says Shinghal.  Evaluate the underlying funds—their strategy, fund management team, track record, etc. “If the FoF invests in debt funds, check their credit risk and duration. If it invests in equity funds, check whether they are diversified or thematic,” says Kalia.  Be mindful if the FoF invests only in in-house schemes, as this limits its investment universe.  Cost is a major factor. “Investors must check the total cost—that is, the expense ratio of the FoF and the underlying funds. This total expense ratio (FoF plus underlying fund) is not readily available for many FoFs,” says Ghelani.  Understand the tax implications. “Tax treatment of an FoF depends on its underlying holdings,” says Shinghal.  

FoFs: Tax treatment depends on underlying assets

 

• Equity FoFs qualify for LTCG if held for more than 12 months
• Equity FoFs are taxed at 12.5% on gains above Rs 1.25 lakh in a year; STCG taxed at 20%
• Debt FoF (with 65% or more in debt), if purchased after 1 April 2023, taxed at slab rate irrespective of holding period
• If bought before this date, get LTCG treatment after 24 months and taxed at 12.5%
• Gold FoFs and international FoFs qualify for LTCG after 24 months and are taxed at 12.5%; STCG taxed at slab rate