Mutual funds dive into FoF waters to fish for debt fund alternatives

Mutual funds' search for debt fund alternatives has reached the fund of fund (FoF) space with at least two fund houses — HDFC and Aditya Birla Sun Life (ABSL) — seeking the regulator's nod to launch FoFs that can offer debt fund-like returns but with better tax efficiency.

Fund houses have been exploring new low-risk product possibilities since the change in taxation in April 2023 when debt funds lost the tax advantage (indexation benefit). Few fund houses like Edelweiss and PPFAS took the hybrid fund route to fill the gap by creating tax-efficient lower-risk products. 

The change in the tax structure of FoFs in the latest Budget has opened the room for more possibilities.

The two proposed products, HDFC Debt Advantage FoF and ABSL Income Optimiser FoF, will invest over 35 per cent of the corpus each in arbitrage funds and debt-oriented schemes. They plan to cap the maximum allocation to the two schemes at less than 65 per cent, according to the fund drafts available on Securities and Exchange Board of India's (Sebi) website.

The launch of the FoFs is subject to approvals from the regulator.

FoFs invest in one or multiple MF schemes rather than buying securities directly. According to the new tax rules, FoFs investing less than 65 per cent in debt funds will qualify for long-term capital gains tax benefit i.e., the gains will be taxed at 12.5 per cent if the investor stays invested for more than two years.

"Such offerings can find a place in investor portfolios, given the tax advantage. However, much will depend on the debt funds they invest in and how well they are managed. In addition, the expense ratio should be reasonable for the fund to compete with other lower-risk investment options," said Rushabh Desai, Founder, Rupee With Rushabh.

Expense ratios of FoFs are generally higher as investors have to pay expenses for both FoF and its underlying funds.

Since the change in debt fund taxation, arbitrage funds have emerged as the preferred debt fund alternative. In the last year, these schemes have raked in over Rs 1 trillion, largely driven by their strong performance and equity taxation.

Experts say the proposed FoFs can compete with arbitrage funds, provided they are managed well.

"Given the mix of arbitrage and debt allocation, the predictability of returns can be higher in the case of these FoFs compared to pure arbitrage funds,” said Rahul Jain, senior vice-president research, International Money Matters.

“The FoFs will have an added advantage if the fund manager has ample flexibility to shift between various debt funds to make the best out of the prevailing market condition," Jain said.

- Select schemes in equity savings category