Given the SEBI restrictions regarding actively-managed mutual funds (MFs) investing in foreign stocks, Fund of Funds (FoFs) investing in foreign exchange-traded funds (ETFs) have emerged as an alternative route for investors. In a bid to cash in on the sentiment, fund houses have launched eight equity FoFs in just six months. But FoFs are not just for equity exposure; they can be used for all types of asset-class based MFs including debt and commodities. Given the expected proliferation of FoFs, currently around 120, here is a low-down on this investment structure.

Explaining FoFs

A plain-vanilla MF invests money collected from investors in equities, bonds, money market instruments and/or other securities. In an FoF, investment is made in one or more MFs rather than investing directly in securities. The underlying fund/s can be of the same fund house or that of a different asset manager. For instance, Quantum Multi Asset FoF invests in as many as six schemes of its own, but in case of ICICI Pru Global Advantage FoF, four out of the five underlying funds are of fund houses other than ICICI Pru.

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Typically, investing in an FoF can be a bit costlier compared to regular MFs. This is because it involves an additional layer of expense alongside the funds in which the FoF ultimately invests. For example, the total expense ratio (TER) of Motilal Oswal Nasdaq 100 FoF is about 0.6 per cent, which includes 0.5 per cent of the underlying fund — Motilal Oswal Nasdaq 100 ETF. If you were to directly invest in the latter, you would save 10 basis points. But investments in ETF can be done only via a demat account and the ETF structure is not friendly to systematic investment plans (SIPs). Hence, FoF scores on these points.

Considering TER regulations, FoFs investing in actively-managed equity schemes and that of schemes other than equity can have a maximum TER of 2.25 per cent and 2 per cent respectively. On the other hand, for FoFs investing in passively-managed schemes and liquid funds, the maximum TER allowed is twice the weighted average expense ratio of underlying schemes, but subject to the cap of 1 per cent.

Three types of FoFs

For plain-vanilla funds, SEBI has set has about three dozen clearly demarcated categories for schemes to fit in. However, this is not the same case for FoFs. Many a time you will see that an FoF might not fall into a specific category. To make this process simple for you, we have categorised FoFs broadly into three buckets.

One, there are FoFs investing in units of one or more ETFs replicating broad-based equity market indices. These ETF FoFs can have domestic focus such as Axis Equity ETFs FoF, which invests in multiple ETFs each replicating indices such as Nifty 50, Bank Nifty, Nifty Next 50 and Nifty Midcap 150. Their TER range is 0.27-0.73 per cent. Then, there are FoFs that even invest in ETFs replicating foreign-based indices and carry a TER of around 0.4-0.7 per cent. For instance, Kotak Nasdaq 100 FoF invests in units of Ishares Nasdaq 100 UCITS ETF.

Two, there are gold FoFs, primarily investing in gold-based ETFs of the same fund house. For instance, HDFC Gold Fund (FoF) invests in HDFC Gold ETF which, in turn, invests in gold and gold-based securities. Gold FoFs come with a TER in the range of 0.38-0.67 per cent.

Three, there are multi-asset FoFs attempting to provide investors with exposure to diverse set of asset classes such as equities, bonds and gold. For instance, ICICI Prudential Passive Multi Asset FoF, carrying a TER of 0.58 per cent, invests in ETFs based on equity indices such as Nifty 50 and Bank Nifty, Bharat bond ETFs and gold ETFs along with providing exposure to international ETFs.

Know your FoF type
Investing in units of ETFs replicating broad-based equity market indices
Gold FoFs, primarily investing in gold-based ETFs of the same fund house
Multi-asset FoFs attempting to provide exposure to diverse set of asset classes

The tax treatment of FoFs is a bit different from other MF schemes. So, pay attention on this front.

If an FoF invests more than 90 per cent in domestic equity securities, then it gets the tax benefit of a regular equity MF scheme. So, short-term capital gains (STCG) will be taxed at 15 per cent if the FoF units are sold within one year. For units sold after one year, long-term capital gains (LTCG) will be taxed at 10 per cent if profits exceed ₹1 lakh a year.

Equity-oriented FoFs with less than 90-per cent exposure in domestic stocks are taxed like a debt fund. This means, in their case, STCG will be based on the investor’s income tax slab if he/she sells the FoF units within three years, while LTCG gains will face a levy of 20 per cent with indexation benefit when these FoF units are sold after three years.

FoF investing

Along with providing diversification benefit to investors, FoF make certain investments accessible. For instance, an investor who doesn’t have a demat account can invest in an ETF through FoF route. Without the FoF way, he/she cannot access ETFs.

FoFs also provide access to various emerging themes such as AI (Artificial Intelligence) and Electric Vehicles, which are available in foreign countries by investing in the ETFs. In India, such themes cannot be played in an optimal way. 

Investors can go for FoFs only when they are the lone route to access the underlying fund. But be wary of taking excessive exposure through the underlying fund/s as it may dilute return/risk experience.