The Mutual Fund Show: How Investors Can Benefit From Fund Of Funds

Fund of funds are mutual funds that invest in schemes like exchange-traded funds, instead of directly investing in stocks, bonds or other securities.

Such schemes are ideal for diversification, according to Raghav Iyengar, chief business officer at Axis Mutual Fund; and Nirav Panchmatia, founder and chief executive officer at AUM Financial Services.

A fund of funds can invest in other equity, fixed income and hybrid schemes, among others. The eventual composition may depend on the offer document.

In India, most FoF offers are for products that offer international exposure. Such schemes invest in international funds registered overseas. These foreign funds, in turn, hold stocks of companies listed abroad. This enables Indian investors to gain exposure to stocks like Alphabet Inc., Apple Inc., Microsoft Corp., Tesla Inc., in a cost-effective manner.

Indian fund houses prefer not to bet on global stocks since Indian investors can get exposure to well-performing global funds via the FOF route, Iyengar said on BloombergQuint's The Mutual Fund Show. He said investment in an FoF adds an extra layer of professional management as it selects the right time to enter or exit an asset class or themes.

On Taxation

Most FoFs are taxed like any other debt mutual fund scheme, even though the fund invests in equity mutual fund schemes. An FoF will have equity taxation if over 90% of its investments are in equity exchange traded funds.

The taxation isn’t dramatically different, said Iyengar. If you withdraw before three years of investment, short-term capital gains are added to the taxable income and taxed as per the investor’s income tax slab. Long-term capital gains are taxed at 20% with benefits of indexation—or adjusting purchase price to reflect inflation.

Except for ICICI Prudential Passive Strategy Fund, no other FoF has equity taxation, Panchmatia said. FoFs are rebalancing tax-friendly as it doesn’t impact taxation in the hands of the investor, he said.

Recommendations From AUM Financials

• Mirae Asset NYSE FANG+ ETF FoF.

• ICICI Prudential Global Advantage Fund.

• ICICI Prudential Thematic Advantage Fund.

• Edelweiss US Technology Equity Fund of Fund.

Watch the full interaction here

Edited transcript of the conversation

Fund of Funds, a lot of times this option comes out, its recommended, by a number of people as well, more on the international investing front. But even on the domestic side, can you talk about what happened?

RAGHAV IYENGAR: Fund of Funds is a very interesting scheme, which is actually given a scheme typically invest in a set of stocks or a set of bonds, or a hybrid fund, I think that’s what we have discussing over the last three, four months, invests in a mix of both of these, a fund of one essentially invests in another scheme, or a set of schemes, so where the underlying where the fund itself goes and puts all his money into another fund or into another set of funds. Now, you would ask me, why do we need to do this. Now if you are, in the earlier days, when the initial Gold Funds came out in the form of exchange traded funds. Now, for investing in ETF, you have to have one demat account, we have to have a brokerage relationship. So many people say that we give us a fund which will invest into that fund. And that actually, was the start of what we call the FoFs. Now, we have various types of fund of funds, investing in domestic equity funds, investing in international funds and that’s the really big innovation that has happened especially in the last 24 to 36 months.

And people like us in Axis have done a lot of work around that. So, it gives you a lot of choice. In some sense, it’s a passive fund because the fund manager, as such is not really buying off out Fund of Fund is really not buying or selling the underlying stocks, he is relying on somebody else to do it. Or he is just going and buying a passive index fund where anyway, the index keeps on moving. So, it’s a beautifully convenient way for people who don’t want to just go the traditional route of investing through a mutual fund scheme, into a set of instruments, which they would normally not be able to, I don’t want to buy directly. On terms of what are the types I think, as I said you can do, it started off with gold. So, in fact, the biggest category of FoFs is very recently used to be gold FOFs. Today, you got what you call ETFs, and you have all types of ETFs, as you know, and that’s something that hopefully we talk about it in coming days is exchange traded funds, which are nothing but funds which are investing in a particular in a particular index, right. So, you have the Nifty ETF, you have the banking ETF, you have the consumption ETF, you have the technology ETF, and these are all the underlying funds. So, you have an FOF which goes and buys into those funds, you have an FoF, which actually goes and buys a combination of these things.

Lastly, of course, the really big category now, which is coming up and really flying in international efforts. So here, we will just go and buy into an international fund. And so, there again there are various types you can do. So, you have funds, which invest into the NASDAQ, your funds, which invest in S&P exchange, we have a fund which invests into Schroeder’s Global Alpha Fund, the Schroeder’s Global Innovation Fund and the Schroeder’s Axis Tech Schroeder’s Greater China Funds, the three things that we have, but there is a whole host of things that you can create. And that’s where there is a lot of innovation. Now, why do people invest in these international funds? I think the biggest thing is that there is something we all suffer from called basically domestic bias, right? I think home country bias is something that in all investors will obviously you will put a majority of your money in what you know. But the fact is that even in developed markets, like in the U.S. which accounted for almost 50% of the entire market capitalisation of the world, U.S. investors invest one fourth of their money outside, right. And that’s what you hear in the market’s daily buys, investing, buying, selling large part of that is also retail customers from other countries, buying into India.

And an international fund that way allows an Indian investor to go out and invest into international equities or international ideas. So there is lots and lots of advantages that you have, by putting money into an effort, to conclude this off course, because taxation is very, very important element when you are investing, so you must know about this, a fund of fund is treated as a taxation is treated like a debt mutual fund, except if the underlying funds are the ETFs that say if I go and create a fund of funds which is going to put money only into ETFs then I think you get taxed as an equity fund which is, if you hold it for more than one year 10% less than one year 15% but in all other types of fund of funds. So, you have to pay like an international fund of fund or debt fund of fund of course, you have to or even a fund of fund investing into other equity schemes. You have to pay tax at that rate, which is anything more than three years is 20% less indexation, anything less than three years is short term capital gains, which is taxed at your marginal tax rate. So that’s a quick five-seven minutes snapshot for you, on the whole FOF structure.

A question that might come to mind for an investor that would a fund of fund that I invested, in turn invest into a mix of equity plus debt or other kind of funds or is it that fund of fund will stick to a category like investments in select equity funds and does it stick to only one fund or can there be multiple funds within the fund?

RAGHAV IYENGAR: That’s a lovely question, because that’s again defined in the offer document. So, let’s say in the Schroeder’s FOF, that we have launched in India, the Axis global alpha fund very clearly in the offer document, we mentioned that this FOF will go and invest all its money into the Schroeder’s Global alpha fund internationally. And obviously, the regulator asked for details of that fund, obviously, they look at various things, they look at the parameters, they look at the size, they look at the track record etc. So, it is essentially defined in the offer document itself, you define that we have on the debt side, the Axis Debt FOF is something which we be now, managing now for the last for more than two years, there very clearly, we have written that we will invest in instruments of debt schemes of domestic mutual funds, right? In fact, that scheme is unique because most of the FOFs in the dead space largely invest in their own schemes here to give us enhanced sense of diversification, we have capped the amount of money we will put internally into Axis and we put large % of money into third party mutual funds, so that the investor gets diversification, and more importantly a different ability to play.

Every fund manager has his own style of investing to try to give him or her the benefit of the style and obviously also the benefit of diversification in terms of number of securities. So, as you can see it is very clearly defined in the offer document and what it can do. You can really construct anything you want, but it’s very clearly defined by thing as a takeover and very importantly, often the funds are not the same, just because they have the last three names FOF doesn’t make it the same category. In fact, it’s a reasonably complex category and you need to read and understand a little more or maybe get in touch with experts in the market and try to find out what exactly it is. So, you have to just essentially go one level lower, as compared to what you would do in a normal equity fund. You have to go one level lower in FOF and see what this FOF can really do, to its portfolio.

It seems that from an international investors perspective or taking an investment or international side, this is probably the most lucrative option to build ultimately. But just before that I heard you mention that taxation is the debt taxation. So, my question is, if I want to take an equity fund exposure, there is this fund of fund or less preferred route simply because I don’t equity taxation, I get that taxation?

RAGHAV IYENGAR: It’s a very valid point. So, if you want and you are really fast about taxation then you should invest in a fund of fund, which is putting all its money into ETFs as the underlying scheme. Like, if you invest in a fund of fund which has exchange traded funds as its underlying then you get the benefit of the equity taxation. But having said that, I think the key thing here is if you want, I think many people, or many investors actually want a sort of solution, where they really don’t want to know what’s happening to their money in terms of, they don’t want to track it, if I may put it this way. So, they have a very, very long-term horizon. So, they want diversification, they want security diversification. So sometimes they may just decide to put money into a manager, for example, who is putting money into other equity funds right and then saying that you manage the whole thing, you figure out how much I should buy a normal regular open ended, large-cap fund or a mid-cap or small-cap fund. So, these are also, there are set of investors who are happy to forego that little bit of additional taxation benefit that you get by putting money into a pure equity fund and coming directly. Let’s not also forget that earlier, of course, if you remember, some time back, equity funds are completely zero tax. Today there is a 10% tax so if it is okay for over three years, you are at about 20% less indexation. So, the longer you hold your money, the lower is obviously the tax rate. So sometimes that difference in tax is not that significant, like it used to be in the past.

Raghav, the other obvious question that comes to mind, what are offers from the Axis’ s side? What is the kind of exposure that one gets, but just before that, it seems to be obvious that on the international front, if I want an international investment, through Axis or whosoever, you in turn will invest arguably, in a fund existing overseas? So, in effect, my investments into any AMCs international offering are effectively an investment to an FoF?

RAGHAV IYENGAR: Mostly, and because very few fund managers have the ability to buy, sell or track research foreign stocks sitting in India, right? And if you have, it’s the same logic of a mutual fund. I mean, why are you interested in an MF money because we are supposed to be doing this, on full-time basis. Most investors do not have the time to really look at that, on a daily basis and the same logic applies in FoF international, right. So, what if I have capability sitting outside? Why should I go and reinvent that capability? I might, as well, feed into that capability. That’s why you have all FoF which are feeding into other funds, you know, the whole idea and this is something which retail investors keep on asking me. What is this feeding, this feeding is nothing when you put money into an FoF that effect essentially goes in invest into another point, that process of investing in another point is called feeding into?

I heard you mention that at Axis you have shown us something and something else, what are the offerings and particularly on the international side, since you guys have that association with the Schroeder’s what is the kind of offering that you have most of the international funds?

RAGHAV IYENGAR: We did some work, you know, Schroeder’s is a very, very preeminent global investment management company, with over a couple of 100 years of experience, largely in active management based out of London. With the AMC Axis they are part owners, its they have a joint venture with the Axis Bank. We have access to obviously, they are really top-ranking funds and a lot of new ideas which frankly, we don’t see coming into India, for the immediate future. So, it allows the investor two things, one is to obviously diversify his overall portfolio because the fact is that when you know, we did this very interesting set of funds where we had a 70% India exposure and a 30% global exposure and then the 30% global exposure, you really went and bought instead of FOMC we went and bought the top stocks in that particular scheme and we had a very, very satisfactory experience.

So, what it did to our investors was it gave you a much better risk adjusted return, rather than just putting money into a pure India equity fund. So, that is obviously number one, it really lowers your risk, number two, which is reasonably obvious is that there are mega companies outside, I mean, today the market cap of Apple is almost equal to the market cap of the entire Indian stock market, right. Yes, you can buy Apple now sitting in India, but yes, there are stocks also, you have to have some expertise, both in buying and selling. So, why don’t you get access to a whole list of companies, which are not traded or available to Indian investors, by investing in it? Number three, which is very, very critical is that the world is pivoting into new businesses right, artificial intelligence, electric vehicles, robotics, clean cities, green energy, these are again companies which are there in India, but they are in a very nascent stage. So, you will find lot of these companies in the private equity space but not in public space. And the world is there, but this is an old theme in the world. In some sense, we are in India now catching up, but these companies are now available abroad and listed and those offerings also are available to Indian investors. Lastly, off course, you have country specific funds also you can buy into U.S. large-cap fund or a China large-cap fund or Europe large-cap fund. So, that’s the other side of the business. Suppose you want to go and buy a U.S. large-cap fund, I think that’s available today to an FoF structure.

So, these are essentially the three, four big to me. The big three reasons are mainly diversification, because a lot of these things that we buy are available internationally, are not going to be in India, are not available in the size that we would like to have or where retail investor may not be available. Number two, it is extremely convenient today. Yes, there is. You can’t go and buy the stocks on your own, I mean, the RBI does offer you the LRS facility, you can go technically and go to a broker and pick up the stocks. But it is there is a little bit of pain involvement. I mean, the process of investing has become simple. But having said that, the other things are not yet easy in the sense of which stock do you buy or sell? How do you research all these talks and things like that? Thirdly, off course, I think very importantly, I think the whole risk adjusted story is really important from an India perspective. Today, lots of our needs are directed abroad, right, we have a fair if you ask most of Indian parents today, especially and across not only urban or even semi-rural, one thought in their mind is either an international holiday or an international education or anything, something to do with international, right. So, I think this investing abroad gives you that benefit, because in some sense, it is not exactly perfectly $ hedged, but it allows you to take benefit of some amount of depreciation of the Indian currency also.

So, I think if you ask me, lots of good reasons to put money, very beautiful way to do it. First, it is super simple. And it is absolute retail fund, you can come in with as low as 5,000 rupees, you can get set up a SIP, you can do everything which you do on a regular Indian mutual fund, can be done with an effort. One thing that you must again, keep in mind is that because we are investing in another fund and the international pay out cycles are a little different from what we follow in India. I must say we must complement our regulator, a lot of monies that are received abroad are not, I think our payment cycles are far, far superior actually. So, in that sense, we may be technically a developing market, but a lot of our processes are actually way ahead of some of the international markets.

So, your outflow when it comes is not normally a T+3 that is T+3 to give the redemption today. Normally in an Indian equity fund, we normally get our money in three working days but here, it could be anywhere from maybe three to seven days, depending on the scheme that you are in and which country you are invested in. So, that again please keep that in mind when you are investing in a fund. And more importantly, when you are redeeming because I have seen many people assume that since India pays in T+3, FoF will also pay T+3 but that is not the case normally, because there is an additional lag of getting money from that international fund into India, then obviously, we are passing it on to the investor. So that’s the second caveat that I would like to just keep it with you. Apart from the first one which I told you that FoF is a common word, but it covers a massive range of investment opportunities available.

I don’t know if you got a chance to hear most of the things that Raghav of Axis was talking about. But is there something which you would want to add to by an investor should or should not choose the FoF options, both on the domestic or international side?

NIRAV PANCHMATIYA: Yeah, I heard Raghav, I think one of the biggest advantages of international FoF, not necessarily domestic FOF is that you can avoid your own country bias. So, I think being Indian domestic investors, we are over exposed, when we see our network, if we have equity investment, whether through mutual funds or through share markets and then we have real estate, all of these are INR assets. So, if we even amongst our friends and families, if you do a survey, very few would be having, barring ultra HNIs. We leave them aside but very few will be having any international currency exposure. Nowadays, when most of our children are wanting to study abroad or leave some people are wanting to settle abroad and there is no Indian would not want to go for vacations abroad. In that case having some form of $ assets is very important to, I think, FOF gives you a takeaway from home country bias and takes you away from single country exposure risk.

Secondly, there is this very important statistic that I would like to share that MSCI World Index Fund as statistically been proven to have a very low correlation with Indian equity market. So, they say that over a three, five, seven and 10- and 20-years period, the correlation between MSCI World Index Fund and Nifty Total Return Index is only point four, that means both these markets, the international market and Indian domestic market, very rarely except for events, black swan events like Covid and all the very rarely they go down together, or they go up together. That I think is a very, very important reason why one should have an international FoF, and another is currency exposure. So, over a five- ten, 15-20 years period again, it is believed that rupee has depreciated at a CAGR of 2.3% over a 20-year period against the $. Now if I am an Indian having any business interest abroad, or if my children are young and they are planning to move for education abroad, this currency depreciation itself will hit me a lot. It doesn’t apply if they are planning to do their education in India that also ensure, you know, asked me to have some international exposure by the International FOF. And It is I think, one of the cheapest ways to have n exposure to a U.S. $ denominated asset, some FOF like a U.S. equity fund or a European equity fund and the day you buy that particular fund, your INR will get converted into USD at the current U.S. $ prevailing rate and when you sell it three, five, ten years down the line, your $ INR will get converted on the prevailing rate, on that date. So, you are basically locking in U.S. $ assets that I believe are three main reasons why you should have an international FOF, and one last major reason would be that there are certain themes, which are still not available in India, in mature markets like India. We are mature but we are not as mature as markets like U.S.

So, there are these fine stocks, Facebook, Apple, Alphabet, Netflix and all. I think it will be another 10-15 years before you have product companies like these in India. How do you get exposure to these stocks? Secondly there are these R&D, Pharma companies like Abbott, Modena are like Pfizer, you don’t have exposure to them here in India. Third, there are these AIML companies, machine learning and artificial intelligence companies and even Raghav pointed out that we will not be having these companies, at least for another decade, in India. So, this is the last major reason why you should have exposure to international FOF.

So, it is sufficient to say that from your perspective of foreign fund exposure should largely be taken, if you want an exposure on the international side, as a divert, as a tool of diversification of your portfolio?

NIRAV PANCHMATIYA: So, any more or less correct, because then it is the cheapest, most economical and safest way to have exposure to international equity. There is a fund from ICCI Provincial, which from time to time based on expertise of the fund manager selects with which sector exposure they should be taking the most and which they should reduce. So, a retail investor is not in a position to decide which sector whether to go for Pharma or exit from or whatever to go for financials, so on and so forth, from that angle even the domestic front often merits but predominantly a FoF is doing a phenomenal job, as far as international FoFs are concerned.

Okay, I read somewhere in the notes you sent that there are made very few FoF options on the domestic side maybe which have equity taxation, most of the funds, I think is to have that debt taxation. So, you can talk a little bit about that?

NIRAV PANCHMATIYA: To my knowledge, there is only one fund out there, one is IKOU funds of passive strategy fund, which is having an equity position by definition of FoF whether domestic or international, enjoys a debt taxation that is by definition, but if a FoF has more than 90% exposure to domestic ETFs which are equity ETFs then that particular fund can enjoy any equity taxation. Right now, to my knowledge, there is only one fund which is enjoying this particular equity taxation, but there are more funds which are in the pipeline.

Got it. It has to do with the taxation, should not be the principal reason choosing in which case we had Axis of course, talk about some of their offerings, but assuming that for a longer case that you choose a fund of an option because you want to diversify on the international side and almost in fact a lot of fund houses, if not all, now have these offerings. Have you been able to analyze some of the main ones and will be able to tell us which of the FoF offering are best suited for diversification perspective?

NIRAV PANCHMATIYA: I believe, everybody in India somewhere if he is an equity investor and even if he is not an equity investor, we dream about companies like Apple, Google, Amazon, Facebook and although now international demat accounts are getting opened in India, but they have their own issues. Setting one of the first fund that an Indian retail investor should invest while the FOF route is a Nasdaq fund. There are many companies like KOTAK and MOTILAL OSWAL of the world which ever Nasdaq 100 or an S&P 500 fund, I think Nasdaq is one such index internationally which is very innovative, completely tech based, and it has many companies, the likes of which are not available in India.

So, one of the first recommendation, I would give is a Kotak Nasdaq 100 FOF or Motilal Oswal 100 FOF. Now, if you want to go one step ahead and if you say I don’t want to have the entire index, Nasdaq index, but you know, I want to have only the Faang Stocks, so there is a beautiful offering from the fund house MIRAE a known as MIRAE asset NYSE FAANG+ETF FoF. Now the beauty about this is that this particular fund, only invests in 10 Faang stocks. So, which includes Alphabet, Amazon, Apple, even two Chinese companies, Alibaba it also invests in Netflix and Nvidia, the chip company and we know there is a huge shortage of chips nowadays abroad internationally, so Nvidia stock is doing phenomenally well.

This particular fund is one of my favorites. Another fund that I would recommend is ICICI Pru Global Advantage Fund. I would like to mention on this particular product, it’s a wonderful FOF in its true sense. It invests in five different geographies, ETF worldwide, so it invests in a USPS fund, it invests in a n Euro base fund, invest in a Brazil based fund and invest in one more geography in Japan is fine from time to time it keeps on rotating this product it reduces or increases the waiting based on the valuation factors. So, that’s a unique product. When we want to invest in a FoF, the first question that flummoxes the investor is whether he should go for U.S. or Brazil, is problem of plenty even in front of FoFs. That problem has ben taken care of by this particular fund. So that would be another fund that I recommend. Another would a U.S. Tech Fund or fund investing in U.S. companies Which are tech savvy. Again, this particular theme is yet to arrive in India, we have seen some great phone companies being listed, but the universe is too small. So, these would be my recommendations.