Not simply the best

PERSONAL FINANCE

While fund of funds promise best results, higher cost and tax treatment could bring down the returns.

When markets go up, stocks and mutual funds become more attractive for investors. And the latter like to drive inflows into their funds by introducing new kinds of products.

In the late 1990s, sector funds, especially IT, were the flavour of the season. Nowadays, the focus is more on global investing. However, there is a new kind of product that wishes to encompass the qualities of a basket of funds.

Namely, Fund of Fund (FOF), this product proposes to help the investor to get the best of the investing styles of different fund managers.

There are a number of players who have launched such funds "" ICICI Prudential, Kotak Mahindra, and Optimix. The basic idea of all these offerings is same: they wish to invest in the best performing funds.

While ICICI Prudential plans to invest the funds into best performing funds within their own asset management company, Optima is looking at investing in the best funds in the market.

Obviously, investors would feel that this is the best way to invest in the market, as they would be part of only the better performing funds. Also, it reduces their own headache to go through the financial jargon and select the fund that would help them get great returns.

Says financial planner Sajag Sanghvi, "FOF is a good option for the people who do not have access to any financial advice."

According to him, if one invests directly in different kinds of funds depending on the asset allocation, one could get better results. For instance, if the asset allocation is 60 per cent equity and 40 per cent debt, then one could allocate the 60 per cent in different equity funds.

Also, some part of that 60 per cent could be aggressively invested in sector funds which are doing well like infrastructure and power. And the debt portion can be taken care of by investing in bonds, floater and post office schemes.

On the other hand, an FOF will invest in different kinds of funds, depending on the fund manager's discretion. And fund managers would depend on the other fund managers' ability and complementary styles to get optimum results.

Adds Hemant Rustagi, director, Wiseinvest Advisors, "It is a tax-efficient manner of investing as there is no short-term tax when the fund manager rebalances the portfolio."

In other words, money can be moved from equity or debt and vice-versa with no short-term capital gains tax on churning. So in some ways it increases the returns.

However, since these funds are treated as debt funds instead of equity, there is a short-term as well as a long-term capital gains tax. That is, short-term tax, depending on the income and the long-term capital gains, will be 10 per cent without indexation and 20 per cent with indexation.

Also, there is a dividend distribution tax of 14.16 per cent. But most important is the fund management cost, which is to the tune of 3 per cent unlike a mutual fund, where it is only 2.25 per cent. Let us look at a few numbers to get an idea of how it works.

For instance, you equally invest Rs 20 lakh in 10 different funds (i.e, Rs 2 lakh in each fund), the annual fee is 2.25 per cent of Rs 20 lakh. That is Rs 45,000 per annum.

The cost of investing the same amount in an FOF is 2.25 per cent on the 10 funds, that is Rs 45,000. Now add another .75 per cent, that is Rs 15,000 for the FOF expense charge and the total balloons to Rs 60, 000.

As an investor, you can take a call on the sectors or funds you are bullish on. But the fund manager in the FOF does not have that liberty.

Rustagi says, "The fund manager could be restricted by the fund's philosophy." This could include only looking at funds which have a corpus of Rs 2,500 crore or have existed for five years or more. This could reduce their ability to make money.