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THE bewildering array of finely differentiated mutual fund products and the absence of reputed fund rating agencies make it difficult for Indian mutual fund investors to pick the right funds to make up their portfolios. Seen in this light, SEBI's recent proposal to allow mutual funds to launch a "fund of funds" (FOF) product appears welcome. Fund houses can also use an FOF as an asset allocation product. Any investor would typically like to apportion his investments across debt, equity and other liquid products, and an FOF may take over this function on his behalf. However, there are a few issues that require to be sorted out:

One key drawback of the fund of funds structure is that investors bear management and administrative expenses two times over. Apart from the management fees charged by the FOF, investors also have to bear expenses for each of the funds the FOF invests in.

SEBI proposes to cap the expense ratio of "fund of funds" at 0.75 per cent of the assets. But this may not be enough. Expense ratios of Indian MFs are quite high; equity funds usually charge around 2.5 per cent annually, debt funds 0.5-2.25 per cent and balanced funds 2-2.5 per cent. When several funds are combined in a portfolio, the expenses can combine to significantly dent returns.

Funds also charge entry and exit loads, which may add to the cost of operations for a FOF. Especially as SEBI has pointed out that churning of the portfolio to accommodate the best funds and timing may be the key advantages of a FOF.

The attraction of the FOF structure will also depend on the tax treatment of its transactions. The Kelkar panel has recently suggested a review of the tax laws that treat MFs as pass-through entities. If this goes through, an FOF may suffer double taxation.

Investors can derive maximum benefit from a FOF if it picks the best available options in the market. This means that an FOF manager will have to impartially evaluate and opt for the best MF products in the market, even if this means choosing funds managed fund-houses other than his own. SEBI may need to stipulate separate AMCs for such funds to avoid a conflict of interests.

Aarati Krishnan

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