Fund of Funds = Cost of costs

The domestic mutual fund industry continues to witness a buzz in the fund of fund (FoF) segment. Leading fund houses in the country have already launched their products and others have firmed up plans to follow suit.

From the investor's perspective the most important question on his mind is -- what does an FoF offer me?

At Personalfn, we wrote an article earlier highlighting the salient features of an FoF. Quite evidently, an FoF is ideal for investors who would like to be as diversified as possible across funds and fund management styles.

However, one aspect of a FoF that rarely gets the attention it deserves is the costs/expenses. We believe that investors should better understand the expenses associated with an FoF before investing in them, notwithstanding the compelling diversification edge. Remember expenses have a direct impact on the return a fund generates.

For illustration purpose we have taken Templeton's Fund of Funds -- FT India Life Stage Fund of Funds, one of the leading FoFs in the country.

Costs keep mounting

As is evident there is a multi-layered cost structure in an FoF. Typically, the expenses are dividend in the investment pattern of the underlying schemes. For instance, take the 20s Plan of Templeton's FoF. The fund invests in Franklin Bluechip (50%), Franklin Prima Fund (15%), Templeton Growth (15%), Templeton Income (10%) and Templeton Income Builder (10%).

The FoF expenses are apportioned based on the investment made in each scheme. So Franklin Bluechip's expenses apportioned to the FoF is 0.96% (half of 1.91%) since Franklin Bluechip accounts for 50% of the FoF's investment.

Over and above this, the FoF has its own expenses (0.75% in the 20s Plan). Based on this, the FoF 20s Plan's expenses amount to 2.71% of net assets, which is way higher than the expenses that regular diversified equity funds incur (Franklin Bluechip itself incurs only 1.91% as expenses).

Of course, investors still need to add a 2.00% one-time entry load in the 20s Plan FoF. So the expenses in the first year of investment for the 20s Plan FoF will be 4.71% (2.00%+2.71%).

Since FoF is a concept/product 'imported' from the US, its only right that we see how the costs work out in that country. To facilitate a like-to-like comparison, we have taken a FoF from Franklin Templeton of USA - Franklin Templeton Founding Funds Allocation Fund to give investors a perspective.

Not as costly

The expenses structure in this case is pretty uncomplicated. While there is a high entry load of 5.75%, the operating expenses are fairly low -- 1.16%.

Anyway you look at it, the FoF cost structure in the Indian context is elaborate and significant. One aspect that needs highlighting with the FoF is that the underlying funds are rebalanced periodically to maintain the ideal allocation level.

In Templeton's FoF, the rebalancing is done every 6 months, so the investor does not incur short-term capital gains in his books, which he would otherwise have incurred.

Viewed in this context, the FoF does not seem as expensive as the higher costs are set off against capital gains tax. Of course, for the investor to incur short-term capital gains, there has to be an upward trend in equity markets over time. Otherwise the higher FoF expenses he is incurring could pull down his investment portfolio.

An FoF allows you considerable benefit in terms of diversification. It also allows you to trim your fund portfolio to include a few FoFs rather than a whole lot of underlying funds. But this comes at a cost, which is justified only if its backed by performance.