Investing in fund of funds? Know the double-cost structure

Understanding mutual fund investment is simple. The mutual fund house collects money from different kinds of investors and invests in a mutual fund scheme managed by a fund manager. But ever heard of Fund of Funds (FoFs)? FoFs are similar to mutual funds. The only difference is the fund house doesn’t create its own MF scheme and rather invests in an ETF or an MF scheme of another fund house. There could be more than one ETF or MFs as well in an FoF.

Fund of funds mostly exist in the international fund category where domestic fund houses pool in money from domestic investors and invest in an international mutual fund scheme. Edelweiss US Technology Equity FoF RegGr, Motilal Oswal Nasdaq 100 Fd of Fd Reg Gr and ICICI Pru Global Stbl Eq(FOF) Gr are a couple of examples of Fund of Funds.

Points to note

What most investors miss out is understanding the cost structure in such fund of funds. In case of mutual funds, you have a defined expense ratio clearly mentioned in scheme details. However, the total expense ratio in case of FoFs is unclear. FoFs will have two layers of cost – one charged by the domestic fund house and another of the MF scheme in which the fund house has invested.

For example, Edelweiss Greater China Equity Off-shore Fund of Fund has its underlying fund in JP Morgan Funds – Greater China Fund. Now the total expense ratio applicable for an investor will include what Edelweiss charges for the fund management and the expense ratio of JP Morgan Funds – JF Greater China Equity Fund.

In some cases, the fund house only declares its own domestic cost. It doesn’t disclose the expense ratio that the underlying MF scheme levies.

“The direct plan of this fund of fund has total expense ratio of 1.43% which includes 0.77% expense charged by underlying fund of JP Morgan. We categorically disclose it in our factsheet. But there are some funds where underlying fund expense is not added while disclosing expense and when prospective investors make a comparison they may get a wrong impression of total fund cost,” said Niranjan Avasthi, Head – Product, Marketing & Digital Business Edelwiess AMC.

What are the regulations?

The trouble is regulations in India only require AMCs to disclose their own fund cost. Markets regulator Sebi has capped the total expense ratio at 2.25%.

Kavitha Krishnan, Senior Analyst Manager Research, Morningstar India, said expenses are closely regulated by Sebi when it comes to FoF structures. She lists the following three points as mandated by the Sebi when it comes to expense ratios of fund of funds that invest in an active fund:

2. i) A TER of a maximum of 2.25% including the expense ratio of the underlying scheme for equity schemes and 2% for non-equity schemes.

1. ii) Expense ratio is capped at the maximum of twice the weighted average cost of the underlying funds, subject to the maximum as above.

iii) SEBI further allows the fund company to charge 30 basis points of expenses for B30 cities.

While the upper cap is fixed, there could be instances when total fund cost has not been disclosed. It is advisable to enquire about the same from the AMC when investing in a fund of fund.

“Disclosure of the expenses on the underlying fund(s)/scheme(s) are made on a voluntary basis by most fund houses. Sebi’s move around expense ratios in 2018 standardised the disclosure norms around expenses. A lot of FoF structures are being launched over the recent period and better disclosure norms are in the best interest of the investing community,” said Krishnan.