What are fund of funds (FoFs)? Do they give better returns?

-Shlok Gupta

FoFs are a type of mutual funds (MFs) that invest in other MFs. There are three kinds of FoFs: those that invest in domestic exchange-traded funds (ETFs), in overseas MFs and some that invest in other domestic MFs. If an investor is looking for the convenience of investing in ETFs without holding a demat account, they can consider the first type of funds (for example, gold mutual funds that invest in gold ETFs). If an investor wants to add a diversified set of overseas investments to his/her portfolio, he/she can consider the second type of funds (for example, ING Optimix Global Commodities Fund). If an investor would like a portfolio manager to take care of his/her MF investment, the third kind of funds can be a choice.

However, there is no case to be made for investing in FoFs to get better returns or to reduce the risk of investments. Also, please note that FoFs have their own management expense on top of the expenses charged by the underlying funds. More importantly, gains from FoFs are taxed on a par with debt MFs even if the underlying funds are all equity funds. Considering these facts, investing in FoFs that invest in other domestic equity MFs is not advisable.

I want to invest 8,000 per month for at least eight years in MFs through systematic investment plans. I have chosen two funds—Templeton India Equity Income fund (Growth) and Fidelity Equity fund (Growth). I plan to invest 4,000 in each. Will I be able to manage a good corpus after eight years?

-Akhilesh Singh

The two funds that you have chosen are good and well-rated funds that have historically performed well. They are both broad market funds—they invest in large, mid- as well as small-cap companies—although the Templeton fund has more exposure to mid- and small-cap stocks than the Fidelity fund that is more large-cap-oriented.

Both funds are benchmarked against the BSE 200 index and have beaten it over different time frames in the past. The BSE 200 gave a compounded annual growth rate (CAGR) of 10.98% in the last five years (as of 31 March 2011) and both these funds have a CAGR of 17.5% in the same period. Though one can’t accurately predict the future performance of the index or the funds based on past data, it would not be unreasonable to expect 12-15% CAGR from your portfolio over eight years. Given your investment schedule, you can expect a corpus of 13-15 lakh at the end of eight years. Of course, much would depend on the performance of the Indian economy and the skills of the fund managers. In any case review your portfolio once every couple of years.

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