Fund of Funds — When a Second Layer Is Worth It

Your money buys units of the outer scheme. The outer scheme buys units of other schemes, which in turn hold the actual securities. Two layers between you and the companies or bonds.

The underlying schemes may belong to the same fund house or to others, and may be Indian or overseas. What the outer scheme is permitted to hold is stated in its documents, and that statement is the most useful thing to read about any scheme in this category.

Many structures in this category exist to hold passive exposures, which puts them squarely inside the argument our page on active versus passive funds sets out, with an extra layer of cost attached.

Everything else about it works normally. Units in your folio, NAV declared daily, redeem when you choose, as our page on what a mutual fund is sets out.

Three situations where the layer is doing real work.

Access to something you cannot buy directly. Most schemes investing overseas are built this way, holding an offshore fund rather than buying foreign securities themselves. Our page on international funds covers that arrangement.

Automatic allocation across categories. Some structures hold a mix of equity, debt and gold in stated proportions and rebalance internally, which means the investor is not making that decision repeatedly. The mechanism is the same one our page on portfolio rebalancing describes, done for you.

Holding an exchange traded fund without a demat account. Several structures exist purely so that somebody without a trading account can hold what an ETF holds, which our page on ETF versus index fund touches on.

There are two levels of charge and this is the main argument against the structure.

The outer scheme charges its own expense ratio, and the underlying schemes charge theirs. Regulation caps the total for this category, so it is not unlimited, but you are still paying at two levels for what is ultimately one exposure.

Whether that is acceptable depends entirely on the first section. If the structure is giving you access to something otherwise unavailable, the second layer is buying you something. If the same exposure could be bought directly, it is not, and our page on the expense ratio explains why an annual charge deserves this much attention.

The test is simple. Ask what the outer layer is doing that you could not do by buying the underlying scheme yourself. If the answer is nothing, the layer is a cost rather than a service.

Worth its own section because the intuition is usually wrong.

How a fund of funds is taxed depends on what the structure holds and on how the rules classify that, and it is not automatically the same as the treatment of the underlying schemes. A structure holding equity schemes is not necessarily treated the way an equity scheme would be.

This has changed more than once, and different types of fund of funds are treated differently from one another. So the position for the specific scheme, at the time you invest, is the only thing worth relying on.

Our page on mutual fund taxation covers the structure without quoting rates. We are mutual fund distributors and not tax advisers, so anything about your own liability should go to somebody qualified for it.

If you hold a fund of funds at all, it is most likely a gold one, and many people holding one do not know that is the structure.

A gold savings scheme of this kind holds units of a gold exchange traded fund, which in turn holds the metal. That arrangement exists so somebody without a demat account can hold it, and so a monthly instalment can be set up, neither of which works neatly with an ETF directly.

The trade is the extra layer of cost, and the question is the same as anywhere else in this category: does the structure give you something you could not otherwise have? For a household without a trading account, it plainly does. For one that has an account and invests in lump sums, it may not.

Our page on gold versus mutual funds covers whether the holding belongs in your plan at all, which is the prior question.

The extra layer makes this harder, which is a genuine drawback beyond the cost.

The fact sheet for the outer scheme shows which schemes it holds, not the companies underneath. To know your real exposure you would have to look through to the underlying schemes as well, and almost nobody does.

That matters if you hold other things. A structure holding a scheme you already own directly is duplicating an exposure invisibly, which our page on portfolio overlap covers. It is the one form of overlap the usual checks will not catch.

Four questions, and the first settles most cases.

• What does the layer do that you could not do by buying the underlying scheme yourself?
• What is the total cost, counting both levels?
• What is the current tax position for this specific type of structure?
• What does it actually hold, and do you already own any of it?

Where a structure gives you access to something genuinely unavailable otherwise, or automates an allocation you would not maintain yourself, it is a reasonable thing to hold. Where it does not, buying the underlying scheme directly is simpler and cheaper. We are distributors rather than investment advisers and we recommend no schemes, but if you want to work out which of those you are looking at, get in touch.