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Suresh Krishnamurthy

Given that AMCs may be reluctant to offer investors the benefit of investment across funds, a fund of funds that practises tactical asset allocation may score in terms of better returns for investors.

A FUND of funds delivers two advantages to investors — selection of funds (manager selection) and tactical asset allocation. Manager selection may, however, remain a pipe-dream as far as investors are concerned. Asset management companies may be reluctant to divert funds that they have mobilised to other AMCs.

In fact, two AMCs — Franklin Templeton and Prudential ICICI — have filed their draft prospectus with SEBI. Neither envisages investments outside of their AMCs. The lack of manager selection can rob investors of a greater portion of the value that a fund of funds can deliver.

Past performance of equity mutual funds also suggests that investments in schemes of more than one AMC is necessary to generate the most from the fund of funds concept.

For example, in the broad based fund category, HDFC Top 200 has been a consistent performer. Similarly, in the mid-cap fund category, Franklin India Prima has been generating better returns. Any fund of fund that does not consider these two funds together runs the risk of under performance.

Rely on tactical allocation: Despite the considerable benefits of a fund manager's selection, AMCs may be reluctant to provide the feature to investors. In this backdrop, only tactical asset allocation — that is, deciding allocation to equity based on expected returns — holds the potential to deliver returns. Investors need to be wary of fund of fund schemes that promise constant allocation to equity and debt.

Such a fund can only deliver returns if it practices manager selection. Since it is unlikely to do so outside of its AMC, such a fund of funds scheme may not deliver significantly higher returns.

In this context, investors can look forward only to tactical asset allocation funds. Funds such as Franklin India Nifty PE Ratio Fund and UTI Variable Investment Scheme (VIS) are some examples. However, these involve index investing of the equity component, robbing them of their charm. With the introduction of the fund of funds concept, the equity portion can be invested in actively managed funds.

Tactical asset allocation may be enough to generate reasonably superior returns even without manager selection. The offer document of Franklin Templeton Low Volatility Fund suggests that the risk-adjusted performance of an asset allocation strategy would have delivered superior returns over the past ten years compared to an equity fund.

Still, investors need to be cautious about investing in such tactical asset allocation funds too. This is because the scheme may be poorly framed.

For example, the Nifty PE ratio fund relies on the level of PE ratio of Nifty to decide allocation to equity. If the PE ratio of Nifty fails to adequately capture of the valuation of equities then the scheme may fare badly.

Similarly, VIS is based on absolute Sensex values. This scheme too may fail to bring out the benefits of tactical asset allocation if Sensex values do not provide meaningful signals regarding equity valuation. In this context, complex models to manage asset allocation appear to be the need of the hour.

Liberal framework: Complex models to manage asset allocation will thrive only in a more liberal framework. AMCs are allowed to charge 0.75 per cent of the net assets of a fund of funds towards their expenses. If the payoff is as low as 0.75 per cent of net assets, AMCs are unlikely to launch funds based on complex models.

In this context, the regulation of such funds needs to be made more liberal. The AMCs must be allowed to launch profit-sharing fund of fund schemes. If the performance of the fund of fund schemes is better than that of the benchmark, a portion of the excess over the benchmark can accrue to the AMCs.

Such incentives may be necessary to induce the AMCs to launch funds based on effective asset allocation models. Such incentives will also force them to invest outside of their AMCs to generate higher returns.

SEBI should also consider allowing banks, insurance companies and pension funds to launch fund of fund schemes. Such institutions are more likely to engage in fund manager selection. They also possess the kind of skills needed to optimise fund manager selection and asset allocation.

At the same time, the institutions enjoy credibility with investors and can thus exploit the fund of funds concept to the greater advantage of investors.

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