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Fund of funds, the diversification alternative

Date: Monday, October 26, 2009
Author: Abhay Rao, Financiaol Express

If one compares mutual funds to the supermarkets of the investment world, a fund of funds (FOFs) would be something of a warehouse available to the retail buyer. “Fund of funds can be extremely useful as they manage expertise of different funds and fund managers,” opines a senior research analyst with a leading investment advisory firm.

They offer an incredible amount of variety, diversification and opportunity to investors, and this has been their key attraction point in the past few years. Also, in India a lot of FOFs allowed asset management companies (AMCs) to invest in their international funds run by their parent or partner firm, taking portfolio diversification to an entirely different level.

Last year, top FOFs scored returns in the range of 50-90% and marginally behind various equity schemes that surged with the market outburst. Market experts reckon that it is during such quick surges that equity funds will outperform FOFs. However, in a negative scenario, the utility of FoFs comes into play as they are spread over several asset classes and many times several markets as well.

FOFs are essentially funds that invest in other underlying mutual funds, making them funds consisting of other funds. These other funds can be invested in by investors individually as well. Most FoFs invest in affiliated funds, which are mutual funds managed by the same advisor. However, there is no such law dictating this and some FOFs invest in funds managed by other advisors as well. Although, the cost associated with investing in an unaffiliated fund is more often than not higher than investing in an affiliated one.

FoFs have also been classified into actively managed funds, in which the investment advisor reallocates frequently among the underlying funds in order to adjust to changing market conditions and to those that are passively managed, wherein the investment advisor allocates assets on the basis of on an allocation model which is rebalanced on a time-to- time basis.

Another type of mutual fund, which also comes under the FOF bracket, is multi-manager fund. While these funds operate on a very similar level, the basic difference is that instead of investing with different funds, the fund invests with different fund managers, giving each one some amount of money to invest with.

In India, ING Investment Management has a variety of multi-manager funds under the FOF segment.

What works

While FoF is still a relatively new concept in the Indian mutual fund space, it is no doubt getting investors’ attention. Earlier this year, fund houses such as DSP Blackrock, Mirae asset and JP Morgan Asset Management launched their FOF schemes, offering domestic investors a chance to diversify their portfolio.

Talking about the Mirae Asset China Advantage Fund, which closed on October 9, Arindam Ghosh, CEO, Mirae Asset Global Investments said, “We have received encouraging response from the investors, however exact numbers of how much we have collected will be provided within few days.” He added that the FOF is a relatively new product in India but slowly it will pick up and that there would be more such products coming in soon. The Mirae Asset China Advantage Fund will be benchmarked against MSCI China Index.

Fund of funds are traditionally segmented, based on the risk an investor is willing to take. Hence, if an investor is retiring soon he should choose a conservative FOF, while someone who still has a while to go before retirement may choose a more aggressive one.

The major diversification advantage of an FOF is it enables one to invest in practically hundreds and thousands of stocks, without taking the risk of a single manager having to manage such a vast portfolio. An FOF allows experts in each category to manage their funds, and hence you have essentially invested in a fund which is not a jack of all trades but hopefully a master of all.

When it comes to portfolio planning, the most pressing question on most investors’ minds, or fund managers’ minds for that matter, is that of right asset allocation. The most commonly accepted don’t, about not putting all your eggs in one basket, is an often-sited fact. However, leading questions like how many baskets should you have or how many eggs should be in any basket at any given point of time are still answers we seek.

Hence, an FOF which invests in an entirely different geographical area or just gives you the option of diversifying across various funds and the stocks invested in each of them, does help in eliminating the overall portfolio risk by spreading out.

As per the Association of Mutual Funds in India (Amfi), domestic FOF schemes, that is funds which invest in other Indian funds, had a total assets under management (AUM) of Rs 822 crore spread over 27 schemes as on September 30, 2009. On the other hand, FOFs that invest overseas had a total of Rs 3012-crore assets under management as on September 30, 2009.

These figures so far indicate that the Indian investors have been moving towards FOFs more for investing overseas, than for the basic advantages an FOF offers in domestic markets. In September itself, an additional Rs 66 crore was invested in FOF schemes which invest overseas.

Look out for

According to Amfi, funds of fund investing overseas collected Rs 400 crores in the month of August. JP Morgan’s Greater China Equity Offshore fund, launched in July, collected over Rs 53 crore, while the rest of the amount was raised by DSP Blackrock world energy fund.

Krishnamurthy Vijayan, executive chairman of JP Morgan asset management said, “The fund did quite well and we hope to raise more money in the coming few months. The main purpose was to give the Indian investor access to China. Apart from this, China and India are currently the fastest growing economies in the world.”

Ghosh added, “China is poised to lead the world out of the global slowdown backed by its domestic consumption and stimulus push from the government.”

While FOFs do offer investors, especially the new ones, a chance to instantly diversify their portfolio with the least amount of analysis or paper work, things can sometimes go awry as well. One of the main contentions here is, say if an FOF through its various fund holdings ends up holding similar stocks via many of these funds, the sole advantage of their diversification offers, would end up completely back firing.

This is where the fund manager’s ability to pick and choose the right funds and managers to back, whilst maintaining a constant look at their holdings, needs to come into play.

But FOFs are a little more costly than the normal mutual funds. This is because the expense fee charged by the underlying funds is added to their own expense fee, making the overall product a little costlier. However, if one were to look at a mutual fund as their solution for not wanting to spend too much time picking individual stocks, an FOF saves you time and anxiety by even choosing the mutual funds worth investing in.

This additional cost while maybe be prevalent, is almost like a premium paid for a better product.

“Fund of funds in domestic markets has not received much importance, however slowly and steadily we are witnessing fund which are investing in global funds. Recently, fund houses like JP Morgan and Mirae AMC has launched schemes which will invest in China. I believe that these funds are launched primarily because the assets which they are investing in are at the cheap price. In the future if any fund houses have international angle in their FOF, then only it will provide better alternative to the investors,” said Sanjoy Banerjee, executive director at ICRA online.

While what Banerjee mentions about international FOFS providing good alternatives to investors ,if they have an international angle ,is true, it would do one good to also keep in mind that even without the international angle, an FOF does have the inherent ability to diversify your portfolio and spread your risks, while still garnering decent returns.

All in all, the FOF market space is still highly underdeveloped here and the number of schemes and offers are bound to keep increasing as the market opens up. Some of the FOFs available to the market have already done well, and it will be interesting to see how do the newer ones do as, for if all goes well, FOFs may well be the new way to go for AMCs and investors both.