Like most investment fads, Fund of Funds (FoFs) were launched with much fanfare. Superior diversification was the main plank for launching FoFs, although the investor had to pay for this by way of higher expenses. Now that many of the earliest FoFs have completed three years in the industry, it's a good time to evaluate their performance.
What are FoFs?
As the name suggests, FoFs are mutual funds that invest in mutual funds. Typically a mutual fund invests in stocks and/or debt. The objective is that the fund should be diversified enough across assets so as to mitigate risks over the long-term. FoFs take this concept to another level; they invest in other mutual funds so that investors get two levels of diversification i.e. (a) diversification at the mutual fund level and (b) diversification at the FoF level.
What are the expenses?
You are probably wondering whether an investor needs so much diversification because beyond a point it can prove to be counterproductive. Nonetheless, the diversification does not come for free; investors incur a cost for investing in the FoF, which is over and above the cost of investing in the underlying mutual funds. So FoFs have a two-layered cost structure.
Have they delivered?
A lot of the FoFs that were launched earlier on have been in existence for a long enough period for a fair evaluation (in our view equity-linked investments must be evaluated over at least 3-5 years). More importantly, they have experienced a market cycle and investors are in a position to evaluate whether FoFs deliver across market phases (market upturn and downturn).
For a critical evaluation, we have compared FoFs performances vis-à-vis those of the flagship equity funds/better performing funds from the same fund house. Also, we have selected the Aggressive FoF option (the equity component for which varies from 60% to 80% of assets) for all fund houses for an accurate comparison.
FoFs: Not good enough
| Open-ended FoFs (Aggressive Option) |
NAV
(Rs) |
6-Mth
(%) |
1-Yr
(%) |
3-Yr
(%) |
Std.
Dev.
(%) |
Sharpe
Ratio
(%) |
| ICICI Pru. Very Agg FoF (G) |
29.02 |
-11.2 |
13.2 |
33.5 |
8.04 |
0.07 |
| Kotak Equity FoF (G) |
30.28 |
-11.2 |
19.0 |
32.1 |
8.61 |
0.08 |
| FT Life Stage FoFs 20s (G) |
27.28 |
-6.4 |
18.8 |
27.9 |
6.17 |
0.08 |
| Birla AAF Agg (G) |
23.30 |
-8.0 |
12.8 |
24.2 |
6.83 |
0.09 |
| |
| Open-ended Equity Funds |
NAV
(Rs) |
6-Mth
(%) |
1-Yr
(%) |
3-Yr
(%) |
Std.
Dev.
(%) |
Sharpe
Ratio
(%) |
| Kotak Opportunities (G) |
40.48 |
-4.3 |
38.8 |
43.9 |
9.04 |
0.14 |
| ICICI Pru Dynamic (G) |
77.52 |
-5.1 |
16.7 |
42.7 |
7.44 |
0.11 |
| Birla Frontline Equity (G) |
65.10 |
-7.4 |
25.5 |
39.6 |
7.14 |
0.21 |
| Franklin Prima Plus (G) |
167.64 |
-12.0 |
19.9 |
38.5 |
7.60 |
0.14 |
(Source: Credence Analytics. NAV data as on April 22, 2008.)
(Standard Deviation highlights the element of risk associated with the fund. Sharpe Ratio is a measure of the returns offered by the fund vis-à-vis those offered by a risk-free instrument)
Volatility
Not surprisingly, the one parameter over which some of the FoFs can claim to have done better than the equity funds is Standard Deviation (a lower Standard Deviation implies lower volatility). This can be attributed to better diversification in an FoF, which is particularly useful during a market downturn.
NAV Performance
However, over-diversification can hurt performance during a stock market rally. The same is evident from the FoFs performances over 3-Yr; over this time frame all equity funds have outperformed the FoFs by a significant margin. Although, the 1-Yr performance is not a good indicator for an equity-linked investment, it is relevant in this case because of the meltdown in domestic stock markets over the last few months. Surprisingly, over 1-Yr, the equity funds have outperformed the FoFs. This tells the investor that superior diversification (the main draw for an FoF) does not necessarily provide him with an edge over a concentrated investment (like an equity fund) during a market downturn.
Risk-adjusted return
In terms of providing a risk-adjusted return (indicated by the Sharpe Ratio), FoFs lag their equity fund counterparts. All equity funds have markedly higher Sharpe Ratios underscoring the fact that, as compared to FoFs, equity funds have provided investors with a higher return per unit of risk.
Put simply, except for controlling volatility, over which their performance is mixed, FoFs have achieved little of note vis-à-vis equity funds over parameters related to risk and return. And don't forget that FoFs charge investors a fund management fee for the service.
Taxation
Equity funds are classified as equities and are taxed accordingly (0.25% Securities Transaction Tax on long-term capital gains), while FoFs are categorised as debt (20% on long-term capital gains with indexation benefit or 10% without indexation benefit).
FoFs or equity funds?
Considering that the earliest FoFs were launched in late 2003, investors have had over four years to evaluate FoFs performances. And as we have seen, the superior diversification offered by FoFs hasn't necessarily provided investors with an edge. Broadly, across most parameters including expenses, equity funds have outperformed FoFs comfortably. This tells investors that equity funds should be the preferred investment option vis-à-vis FoFs.
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