Favourable change in taxation, regulatory push for Fund of Funds: Should you invest in FoFs now?

Time of India

05-05-2025

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A mini-revolution is unfolding in the fund of funds (FoF) arena. Currently a space only sparsely inhabited by investors and AMCs, it may soon catch the fancy of more. FoFs invest in one or multiple mutual fund (MF) schemes rather than buying securities directly. The underlying investments for an FoF are the units of other MF schemes either from the same MF or other MF houses.Buoyed by a favourable shift in the tax regime, FoFs are being seen in a new light. Mutual funds are increasingly introducing more products in this avatar. Moreover, Sebi has introduced a fresh framework for FoFs, enabling their classification into distinct categories and opening the door to innovations. But do FoFs really offer a compelling proposition, distinct from existing plain-vanilla funds? Are any of the offerings worth exploring?For long, FoFs were treated as tax outliers in the mutual fund space. They were classified as 'non-equity funds' for tax purposes, regardless of the underlying asset class. Only FoFs investing over 90% in domestic equities were taxed on par with equity funds . Until 2023, gains on any FoF got taxed at 20% after indexation, if sold after three years. This created a disadvantage for certain FoFs compared to their plain-vanilla counterparts. For instance, FoFs investing in domestic equities and international equities were taxed as non-equity funds, even as mainstream funds investing in the same assets enjoyed favourable, lower LTCG taxation as equity funds.After the Budget 2023 removed LTCG benefits for non-equity funds, FoFs became even less attractive. Gains from all non-equity schemes, including FoFs, started getting taxed at the investor's slab rate. The July 2024 Budget breathed new life into FoFs. These now benefit from a uniform 12.5% LTCG tax if held for over 24 months, making them more tax-efficient. Under the updated Section 50AA, only funds with 65% or more in debt instruments are now classified as 'Specified mutual funds' and taxed at slab rates, regardless of holding period. FoFs, whether investing in domestic equities, bonds, commodities, international assets or a mix of assets, no longer get clubbed into this space.Vidya Bala, Head of Research, Primeinvestor.in, says, 'FoFs earlier lost out on taxation, but can now stand on an equal footing with other mutual fund offerings.' Manish Goel, Founder and MD, Equentis Wealth Advisory Services asserts, 'The Union Budget 2024 offered a new lease of life to FoFs.' This change levels the playing field, boosting the case for FoFs as a taxefficient diversification tool, adds Goel.With a tax-friendly regime buoying investor interest, fund houses are exploring the FoF route for differentiated offerings. Currently, there are 94 FoFs, managing assets of `97,260 crore. Most of these are domestic feeder funds investing in a single underlying ETF. Fund houses typically launch an FoF variant for their ETFs, to enable investors to invest in these ETFs even without a demat account. Investors are assured of liquidity in FoFs, as the investments happen through mutual fund houses, not via exchanges. Among these are 53 overseas FoFs (in the form of feeder funds), managing assets totalling Rs.25,030 crore. These either invest in an overseas mutual fund or an international index. Only 39 multi-scheme FoFs—those investing in two or more schemes—are currently available. Most are asset allocator or multi-asset funds, combining exposures to equity, bonds, gold, and more. The Rs.24,412 crore ICICI Prudential Asset Allocator FoF is the largest in this category. Of these, around 18 are multimanager FoFs that also invest in schemes from other fund houses. The biggest among them is the Rs.1,272 crore Franklin India Dynamic Asset Allocation FoF. Clearly, the universe of multi-scheme FoFs has limited offerings.This could change soon, aided by the tax shift and regulatory blessings. Many AMCs are bringing in innovative offerings in this space. For instance, mutual funds are actively turning to the FoF space in search of alternatives for debt funds. AMCs are now combining fixed income with arbitrage within the FoF framework. Even as gains from a traditional debt fund are taxed at the investor's slab rate, the FoF alternative will incur 12.5% tax on gains after two years. This presents sizeable tax savings for those in the higher tax brackets. Seven existing debt funds have been repackaged as income-plus-arbitrage schemes. Multiple new schemes are being launched too.Sebi seems keen to open up the FoF space further. The regulator dictates the categories of schemes that can be launched by a fund company. AMCs need to classify schemes into distinct buckets, lending a clear identity to each scheme, with a tightly defined investible universe of securities. Among these, mutual funds are also permitted to offer FoFs under 'other schemes' category. However, rules currently don't specify what funds can be offered under this umbrella. The target investment universe for these funds is also not defined. To enable more structured growth in this space, Sebi has introduced a classification framework for FoFs holding two or more schemes.Earlier, all FoFs were taxed as nonequity funds, leaving them at a disadvantage to plain-vanilla funds.Under this framework, AMCs can launch multi-scheme FoFs across six broad categories (see graphic), some of which include sub-categories. For example, within domestic equity-oriented FoFs, AMCs may offer two diversified FoFs (any mix of market caps) and multiple thematic or sectoral FoFs. In the hybrid FoF category, one fund each is permitted under aggressive hybrid, conservative hybrid, income-plus-arbitrage, dynamic asset allocation, and multi-asset allocation sub-categories..Experts believe the move will bring muchneeded clarity to the FoF space. Rushabh Desai, Founder, Rupee with Rushabh Investment Services, says the scheme categorisation and capping will help streamline this universe. 'The FoF space was at risk of going haywire, with any number of schemes, with any permutation and combination getting launched.' The framework also opens up new possibilities for distinct solutions. Nirav Karkera, Head of Research, Fisdom, says, 'This is a developing space. The canvas is blank right now; innovation can happen in any corner.' Goel remarks, 'The framework allows fund houses greater design freedom—enabling hybrid combinations of domestic and global funds, active and passive styles, and multi-thematic allocations under a single product.'Investors may finally see a wider choice of true multi-manager FoFs, with a single fund investing across multiple schemes. Bala asserts, 'With multi-manager FoFs, the asset management company also becomes a portfolio adviser to the investor, managing a basket of funds rather than the investor picking and managing on his/her own.' When investing on their own, investors incur costs while rebalancing between individual schemes. With multi-scheme FoFs, there is no capital gains tax when the primary fund rebalances internally between two or more funds. Goel says, 'For investors, this means access to well-constructed, diversified portfolios with lower operational overhead. For the industry, it marks a shift from cookiecutter funds to next-generation offerings tailored to evolving investor appetites.'All FoFs must be classified into categories, and number of offerings capped.An expanding FoF universe may seem appealing, but as seen in the broader mutual fund space, more variety often leads to clutter and confusion. Joshi notes that plainvanilla funds are enough for most investor goals. 'There are enough options in traditional MFs. Investors don't need to chase every new product or category,' he says.These are mostly investing across multiple asset classes.Besides, FoFs also come with drawbacks. Unlike direct investing, they offer limited control over the selection of underlying schemes. Karkera remarks, 'In an FoF, you have to live with the fund choices of the asset manager, taking the good along with the bad.' Even if you prefer having fund selection taken off your hands, there is no assurance the mutual fund will do a better job of choosing funds. Desai says, 'The FoF investing in multiple funds needs to be managed really well if it is to take up the onus of portfolio construction for you.' Karkera observes, 'Complexities in fund selection are distinct from individual security selection. Most fund houses have not built enough capabilities to evaluate other asset managers' funds.'Investors must also contend with higher costs. Goel asserts, 'The dual expense structure—at both FoF and underlying fund levels—can eat into returns, especially in actively managed products.' However, some ideas may be worth exploring. For those seeking international exposure, overseas FoFs may offer differentiated solutions in a tax-friendly avatar, without navigating foreign investment complexities, says Goel. Overseas indices or themes not available in India are worthy options. HDFC Developed World Indices FoF, DSP Global Innovation FoF and ICICI Prudential Global Advantage Fund are examples. Goel also favours multiasset FoFs for moderate-risk investors seeking balanced returns. ICICI Prudential Asset Allocator FoF, HDFC Asset Allocator FoF, Kotak Multi Asset Allocator FoF and Franklin India Dynamic Asset Allocation Fund of Fund are some prominent names. Meanwhile, investors may avoid sectoral or thematic FoFs. 'Bundling multiple sectors is like a diversified fund and defeats the purpose of focused sectoral bets,' says Bala. Income-plus-arbitrage FoFs can be tax-efficient alternatives to regular debt funds, but come with a distinct risk-return profile.Very few schemes operate as true multi-manager FoF.s