In the plethora of mutual fund categories there are, one that appears to be slowly gathering pace are the fund-of-funds (FoFs). On the face of it, FoFs are nothing but funds that invest in other funds. But that simple definition belies the complexity of the funds in that category. Under the giant umbrella that is the FoF category, you have the following:
- FoF investing in the AMC’s own equity funds, its own debt funds, or in a mix of equity and debt (often called asset allocator funds). The funds here could be active, passive or both.
- FoFs that invest in a combination of own-house funds as well as funds from other AMCs – both in equity and debt. Here again, the underlying funds could be active, passive or both.
- FoF investing in overseas ETFs or overseas mutual funds (i.e., feeder funds)
- Passive FoFs investing in the AMC’s own equity or debt or gold ETFs/index funds or another AMC’s passive investment options.
All four FoF categories have been seeing a growing population. But the fourth category – the passive FoFs – is the new kid on the block. The swelling interest in passive investment options saw AMCs launch dozens of ETFs. And since it’s easier for mutual fund investors to stick to funds, AMCs launched FoFs that invested in those ETFs.
With more passive options in their kitty, AMCs began to capitalise on these by launching funds that invested in a basket of ETFs/index funds. These passive FoFs, because they offered a more diversified approach, caught investor attention. The newest launch here – ICICI Pru Passive Multi Asset FoF – garnered a respectable Rs 767 crore in AUM in January. We have also fielded questions from you on these passive ETF FoFs. So, are these diversified ETF FoFs good portfolio additions? Where do they invest and how has their performance been? Here’s a look.
What ETF FoFs do
A plain-vanilla ETF FoF simply invests in one ETF. For example, a gold FoF would invest in that AMC’s gold ETF. The Bharat Bond FoF will simply hold the Bharat Bond ETF.
A more diversified passive FoF doesn’t stick to one ETF or index fund, but instead holds a mix. There are, currently, six such diversified passive ETF FoFs. Their portfolios can be:
- All equity – that is, the underlying indices in the portfolio will all be equity. Typically, these would be the Nifty 50 or Nifty 100, the Nifty Midcap 150 or the Nifty 500 though funds such as ICICI’s passive FoF also hold sector ETFs. These FoFs, barring Nippon India Passive Flexicap which has an index fund, invest only in ETFs. These funds are best compared to flexi-cap funds in the active space.
- Asset-allocated – that is, the underlying portfolio indices are a blend of equity and debt and gold. The allocation to each asset class moves within a range. On the equity side, index options remain the main market indices. On the debt side, given the passive options currently, are usually the g-sec indices of that AMC.
The table below gives a brief on where each of the current passive FoFs will invest.
Performance
These funds being new don’t have much of a track record; most of them are just about a year old. Therefore, on the returns front, its hard to judge how these funds will deliver. The funds are also quite different in their allocations towards market caps and their investment approach.
For instance, the Nippon fund decides its market cap allocations based on the industry’s allocation to large, mid and small cap each month. That is, it more or less sets store by the collective industry wisdom. The ICICI Passive Strategy on the other hand, uses a mix of market-cap indices and sector indices. The Mirae fund simply uses the main market-cap indices.
Considering 3-month rolling return over the past 1 year, the three all-equity passive FoFs above beat the Nifty 50 more than half the time. Stretching into 6 months also shows a similar ability to beat the Nifty 50. Against the broader Nifty 500, however, only the Nippon fund appears to be showing performance mettle. Do note though, that this is far too short a timeline to be looking at performance.
On downside containment against the Nifty 50, all the passive FoFs have managed well (excluding ICICI Pru Multi-asset FoF as its new) and fallen to a lower extent. Obviously, the two Motilal funds have fared better owing to their debt/gold allocations. The FoFs are also marginally lower on volatility. The short-term performance appears to suggest that these funds do behave differently from the Nifty 50 index or the broader market Nifty 500 index. They are therefore worth watching to see if performance compares well with active funds.
The pros and cons
But while returns may start to shape up in these funds, do they make good portfolio additions? To get there, the following aspects assume importance.
#1 Differentiated play
For those who wish to invest in passive options, the passive FoFs offer a good way to access multiple indices in one go. For one, you may otherwise not have the portfolio bandwidth to invest in a variety of indices. For another, funds also change allocations to the different indices based on markets and to that extent could meet your need to book profits where needed and shift to where opportunities are. Since the allocations happen within the fund, you wouldn’t have to bear any tax that you may otherwise have to if you were to do it yourself.
This apart, barring the ICICI Pru Strategy fund, the others have fairly simple list of ETFs they plan to invest in and could thus be easier to understand and track performance. As explained above, performance does appear to be able to beat at least the main Nifty 50 index.
On the other hand, passive FoFs also restrict you in terms of what indices to go for. It pulls away the ability to make allocations to different market-cap segments based on what you already hold in your portfolio. If your portfolio can accommodate different types of indices such as factor indices, or allows you to take different exposures to mid-caps or small-caps and so on, passive FoFs are not really of help.
#2 Portfolio
Fund-of-funds in general try to tick off the checkbox above – that of switching allocations to different funds based on performance without you having to do it yourself. Passive FoFs steal a march on these FoFs simply because their underlying funds are just indices and address the performance risk to a large extent. In other FoFs (which we will cover separately later), you are not only taking the risk of the FoF identifying the right funds but also the performance of the underlying active funds.
The second way passive FoFs are a better bet than active FoFs is their low expense ratios – both their own and from their underlying ETFs/funds. Consider the FoFs themselves, first. The average expense ratios of the passive FoFs work out to about 0.08%. The average expense ratio of all (domestic) equity FoFs together is higher at 0.37%.
Next, take the universe of the funds that these FoFs could invest in. The average expense ratio for all ETFs together, works out to 0.24%. Obviously, that’s far lower than the average expense ratios that equity funds or even many debt funds would sport. The flexi-cap category, for example, has an average 1% expense while large-cap funds hold at 1.09%.
#3 Taxation
The tax aspect is where passive FoFs falter. According to tax rules, if the FoF invests at least 90% of its portfolio in equity ETFs and that equity ETF in turn invests at least 90% of its portfolio in domestic stocks, then the FoF is treated like an equity fund. Otherwise, the FoF will assume debt tax status. So, if the FoF has a debt ETF or debt index fund, or an international ETF or index fund, or even an equity index fund as the underlying, it will not qualify as an equity fund for tax purposes.
In the list of funds above, the ICICI Passive Strategy and the Mirae fund alone will qualify for equity taxation. The Nippon fund, though being all-equity by nature, has an index fund in its portfolio. Therefore, depending on the fund, you may have to forgo the equity taxation despite being more or less invested in equity.
Suitability
Passive FoFs have factors both in and against their favour. Therefore, use the following guidelines to decide whether these funds are for you:
- For those with smaller portfolios, where allocating to differentiated options or to more funds is hard, passive FoFs can be good additions. If you already hold index funds or ETFs in such portfolios, these can still be differentiators as they blend indices. You can look at the underlying indices that the FoF will invest in to decide if it complements your portfolio.
- For those who want simple passive allocations in their portfolios – i.e., just the benchmark indices without going for specialised options such as factor/ sector/ thematic indices – passive FoFs can fit the bill. You can, of course, always hold indices such as the Nifty 50 or the Nifty Midcap 150 or even the Nifty 500 directly, here.
- For investors with large portfolios, and especially those who are more seasoned investors, passive FoFs do not add much value. For one, 1-2 such funds can up the concentration risk – while the underlying is passive, there still is an element of risk in the way the funds allocate between the indexes. Two, you will have greater control over what indices to go for, from which AMC to choose as well as how much to allocate based on the active funds you already hold. With the variety of ETFs and index funds available, larger portfolios can well be designed to include a better set of funds than what the passive FoF would offer you.
If you’re using such passive FoFs in your portfolio, be clear about its tax status. Additionally, know that performance is still important in these funds even though they are passive; funds are yet to build a track record and therefore, don’t rely entirely on recent performance.
