Fund-of-funds: Can it offer tailored investment solutions?

This article discusses fund-of-funds and shows how the structure adds value through manager selection process. It also discusses how such funds can offer better investment solutions and urges asset management firms to offer more such products in the future. 

According to the Web site of the Association of Mutual Funds of India (AMFI), there were 1,043 funds in the country as on September 30, 2008 with assets under management totalling Rs 4,20,862 crore. With 280 equity funds and 471 debt funds, it is small wonder that investors find it difficult to choose appropriate funds to construct an optimal portfolio. 

That is why fund-of-funds becomes a valuable vehicle for investors. 


Paradox of choices 


Fund-of-funds, prima facie, appears a redundant investment vehicle. Such funds after all take exposure to other equity and bond mutual funds — a process that can be easily replicated by investors themselves. The problem is that investors are not as competent as professional money managers at identifying style cycles and manager skill. 

Suppose a person wants to invest Rs 10 lakh today to pay off a certain liability in five years. How should she construct her portfolio of mutual funds? What if she chooses an infrastructure fund when the sector is at its peak? 

Selecting underperforming funds could prove disastrous because the investment will not be able to pay off the liability structure at the horizon. That is why identifying style cycles are important.

Now, take a discerning investor. Suppose she wants some exposure to large-cap value, mid-cap growth, long-term bond fund and a money market fund. As there are many funds available, the investor has to develop some criteria to choose a fund in each category. 

Often, this means choosing the best performing fund in the last one, three and five years. This is not an optimal selection process because no money manager can consistently beat the market.
Manager Selection 


Assume that the market has only 25 professional money managers. If five of them beat the market, it means some others underperform while the rest form the market average. The next year, these five portfolio managers may generate average returns. Later, they may grossly underperform the market. 

Some of the best-performing portfolio managers in the US before 1997 underperformed the Nasdaq during the dotcom era when they failed to ride the technology cycle. 

Selecting portfolio managers who have performed well in the last three years could, hence, be optimal only if their investment style is in vogue in the future as well. 

And that is difficult to forecast. That is why selecting funds that can consistently generate excess returns over the benchmark index (alpha returns) is not so easy. 

A fund of funds structure helps in this regard. The manager of such a fund is expected to have better manager selection skill than an average investor. She also understands style cycles and can, therefore, engage in tactical asset allocation. 

This involves switching from, say, mid-caps to large-caps and from one sector to another to generate excess returns.

The additional layer of cost (MER of 0.75 per cent) that fund-of-funds charge is a compensation for adding value through the manager selection process. 
Offering investment solutions? 



Currently, there are not many fund-of-funds available in the market. Of the ones that are available, some invest only in their own family of funds. Such exposure may not be optimal. The reason is not far too seek.

The best performing mid-cap style, for instance, may be a fund from a competing asset management firm. Taking mid-cap exposure within the family of funds would then be sub-optimal.

But why not use fund-of-funds structure to offer investment solutions to people? This can be achieved using fund-of-funds as a conduit and single asset-class funds as the building blocks. 

Take children’s education fund that some asset management firms offer. Such a fund invests in both equity and bonds and sometimes engages in tactical asset allocation. 

The manager risk is high, as the portfolio manager takes exposure to both asset classes within one fund. Manager risk is the risk that the portfolio manager may underperform her style benchmark.

An optimal alternative would be to offer such exposure through the fund-of-funds structure. Such a fund could take exposure to large-cap index fund, mid-cap active fund and a gilt fund. This reduces manager risk as all managers will not underperform at the same time.

Index funds vs diversified funds - Ways to beat market

The steep decline in the equity market in 2008 has wiped out a large part of investors’ wealth, irrespective of whether they took the direct investment route or went through mutual funds. In a volatile market such as the present one, predicting short-term movements and timing the market, despite the steep corrections already witnessed, remains a challenge. 

In uncertain times investing through index funds may be a better option if one prefers to go with the market tide. The one-year return clocked by the index funds is between -41.5 and - 47.5 per cent, as against BSE Sensex and S&P Nifty decline of 54.7 per cent and 54.3 per cent respectively. 

The divergence between the benchmark performance and the index funds is due to tweaking of the portfolio with minor changes in the weight of stocks held and cash position of the funds. During the same period diversified funds have declined in the range of 34-74 per cent.

Index funds are passively managed funds and mirror the index by holding the index stocks in similar proportions. Being passively managed, index funds have lower expenses than diversified funds. On the other hand, active calls taken by diversified funds can work against them in unpredictable markets in the short-term, resulting in higher declines. 

Diversified fund managers tend to take aggressive or contrarian strategies to outpace their respective benchmarks. Over bullish phases an active fund manager seeks to score a high beta over the benchmark, while also generating consistently superior risk-adjusted returns (called alpha) over the long term. 


Over three- and five-year periods, diversified funds outpaced the index funds by a huge margin. Magnum Contra, an open-ended diversified fund with a good track record, generated a compounded annualised return of 31 per cent over five-year period and outpaced the HDFC Index Fund Sensex Plus Plan by 16 percentage points. However, these funds have outpaced the benchmark BSE Sensex and S& P CNX Nifty over the same time-frame. 

Selecting an index fund requires less effort than choosing a diversified fund. An individual can choose a Sensex or Nifty fund based on his/her risk appetite. However, in diversified funds one has to look out for various aspects such as the fund’s long-term track record, investment style and objectives, along with the fund manager’s ability to produce positive alpha.

RBI aid puts mutual funds on recovery road

     Almost one month after the RBI stepped in to help the mutual fund industry out of its liquidity problems, it does appear that they are on the road to recovery, said mutual fund officials.

RBI had for the first time on October 14 introduced a 14-day liquidity window to provide credit to mutual funds in need. This measure has greatly helped the mutual fund industry, which is now returning to normalcy as redemption pressure has eased considerably and inflows have started to come in, said Mr A.P. Kurian, Chairman, Association of Mutual Funds in India.

The mutual fund industry has borrowed close to Rs 20,000 crore from RBI, out of which about Rs 9,000 crore has been paid back, said Mr Kurian.

While the borrowing was much less than the limits provided by RBI, the announcement of the measures was made at the most appropriate time. Else there was a possibility of three or four fund houses going bankrupt, said Mr U.K. Sinha, Chairman & Managing Director, UTI Asset Management Company.

The first liquidity measure, which was introduced on October 14, just four days ahead of the monetary policy, came as a complete surprise as far as its timing was concerned.
Woes of industry 



The problem of the mutual fund industry was a mix of liquidity crunch and credit aversion. While the liquidity issues have been dealt with, the credit aversion is easing off slowly, said Mr Ramkumar K., Head-Fixed Income, Sundaram BNP Paribas Mutual.

In October, redemption requests from corporates were unusually high because of the lack of confidence and the liquidity crunch, said Mr Sinha. With the money market having dried up and banks not trusting each other, corporates felt it safer to withdraw their cash from mutual funds and park it with themselves, Mr Sinha said.

In October, no institutions, including banks, were willing to buy any papers (CDs or CPs), said Mr Badrish Kulhalli, Senior Fund Manager-Debt, Principal Pnb Asset Management Company.

While banks were not willing to lend, RBI indicated to the banks and corporates that the Government would lend support to the mutual fund industry, which helped improve the scenario, said the mangers.

The response to RBI measure was lukewarm in the first phase. Continuous dialogue and easing off of higher interest rates helped improve the issue. While banks had agreed to lend to mutual funds, the cost of borrowing was high for the funds, who in most cases do not make much money on their liquid schemes, said Mr Waqar Naqvi, CEO of Taurus Mutual Fund.

RBI’s relief measures have helped the industry considerably, to the extent that earlier while CDs were being borrowed at interest rates as high as 13-14 per cent, they are now at 10 per cent, said Mr Ramkumar.

It would have helped mutual funds better if the tenure for the liquidity window was flexible as some mutual funds were reluctant to borrow on a 14-day lock-in period and would have preferred a lesser time span, said the head of a mutual fund house.

However, the problem will be permanently addressed only when the mutual funds’ sources of funds, namely the corporate houses and investors, start investing in the usual way, said Mr Naqvi.

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More relief under way for rupee hit exporters

Exporters reeling under the dollar slide could be in line for a slew of reliefs in the Foreign Trade Policy coming up next month.

The steps being contemplated by the Commerce Ministry range from possible reimbursement of, or rebate on, some of the taxes incurred on export production; to zero duty EPCG (export promotion capital goods) scheme in place of the five per cent concessional duty, possibly for the first time.

These and a dozen other sops are being considered to mitigate exporters’ losses due to the rupee’s 11 per cent appreciation against the dollar, according to a note circulated by the Commerce Minister, Mr Kamal Nath, at a meeting organised by the Federation of Indian Exporters’ Organisation here on Friday.
Export growth


He said he still expected an export growth of 20 per cent this fiscal over 2006-07. The target is $160 billion. “The abatement of service tax on all services related to export production and delivery of exports” is being examined. The Government is also debating a scheme to reimburse or discount even State levies such as octroi, mandi tax, electricity duty that are currently not reimbursed.

Those exporting more than 75 per cent of their production may also get the EPCG benefit without any binding on average EO (export obligation).

Textiles and automobiles may also get the benefit of duty-free import of R&D equipment up to 25 per cent of f.o.b. value.

Mr Nath said, “The worldwide slowdown driven by the US (dollar slide) is a problem but there are other engines of growth” such as Europe, Africa and China. “We are looking at country-specific duties and we are going to have trade agreements.”

With Japan, for instance, there had been a breakthrough in the MFN (most favoured nation) negotiations. Europe and top African countries were the other preferred baskets that were being pursued.
SHORT OF TARGET


Total exports are likely to touch $ 150 billion by the end of March, falling a little short of the targeted $160 billion, according to Mr Sakthivel, Vice-President & FIEO Regional Chairman. He said exports from labour-intensive and employment-intensive sectors like textiles, readymade garments, handicrafts, leather products had declined.

Calling for a dual rate system for exporters, he said, “With the support of the Government, we are sure that exports will accelerate in the last quarter.” He urged the Minister to take up the issue of RTAs (regional trade pacts) that were eating into Indian export markets.

The FKCCI President, Mr S.S.Patil, said infrastructure such as electronic data interchange would cut export cost and bring the $ 200-billion export target for 2008-09 closer.

Inflation surges to 40-month high

RISING INFLATION :

   With no let-up in prices of vegetables, milk, edible oils, fuels and iron and steel, inflation spiked sharply to its highest levels since November 2004, even as fresh industrial production data reflected signs of a pick-up in output.

  The easing of concerns about the extent of a slowdown in the broader economy, amid the sustained upward spiral in price levels, increases the odds that the RBI might opt to tighten monetary policy when it holds a review at the end of the month, analysts point out.

  The annual Wholesale Price Index-based inflation rose 7.41 per cent during the week up to March 29, up sharply from the previous week’s 7 per cent rise. During the latest week, wholesale prices in the iron and steel category were up a whopping 34 per cent on a year-on-year basis, while edible oil prices shot up 20 per cent.

  Among essential items, cereal prices jumped 7 per cent, vegetables were up 16 per cent, while prices of both milk and spices spurted 8 per cent in the wholesale markets. Dairy products were up 9 per cent, while cement prices jumped 5 per cent. In the fuels category, both mineral oil and coal prices were up 9 per cent.

  Meanwhile, industrial production grew 8.6 per cent this February from a year earlier, higher than January’s upwardly revised 5.8 per cent rise, according to IIP data released on Friday. This, however, was lower than the 11 per cent recorded during the same month a year ago.

  During the month, manufacturing clocked an 8.6-per cent growth, electricity generation was up 9.8 per cent while mining output was up 7.5 per cent.

  The strongest growth was in consumer non-durables, including items such as toothpaste and soaps, which rose 11 per cent from February a year ago, while momentum in the capital goods segment picked up, with a 10.4 per cent rise in output after January’s dismal 2.1 per cent (pre-revised). Consumer durables recorded a 3.3 per cent growth.
Ban on exports


   Adding to the series of measures already in place to curb rising prices, the Government on Friday announced a ban on cement exports, besides withdrawing export incentives for rice and primary steel items in its new Foreign Trade Policy. The Government has already banned export of non-basmati rice, edible oils and pulses in an attempt to curb inflation.

    The Cabinet Committee on Prices is now slated to consider a fresh set of proposals next week, including a ban on steel exports.

The Cabinet panel is also likely to consider proposals like a cut in excise duty on finished steel and scrapping customs duty on imported steel.
‘Global phenomenon’


  Responding to the latest inflation numbers, the Centre termed soaring prices as a global phenomenon and said it was taking all possible steps to contain the rise. “The Government has no magic wand to bring down inflation. Due to a rise in prices worldwide, it has become an imported inflation,” the Minister for Science and Technology, Mr Kapil Sibal, said while briefing the  mediapersons after a Cabinet meeting here.