Fund of Funds Structure: Two Layers of Cost and Tax
A fund of funds is stacked in three levels: the holder, the outer scheme, and the underlying schemes it holds. Each scheme charges against its own assets, and because the outer scheme's assets are the inner units, the two charges add. The inner charge is already inside the value the outer scheme uses, so no statement shows it. How the holding is taxed is set in tax law.
Here is what sits underneath that. A scheme that holds other schemes is not one charge wearing two names. A scheme that holds other schemes carries two separate charges, struck by two separate parties, on two separate pools of assets, and the holder meets the total of both without ever being sent a bill for either. That second charge has an arithmetic of its own, and there is an exact line between what the structure decides and what it hands to somebody else.
One arrangement runs through every worked figure that follows. Girnar Asset Management Limited operates a scheme that holds other schemes, called here the Girnar Multi Scheme Portfolio Fund. The Girnar Multi Scheme Portfolio Fund is the outer schemeThe scheme whose units a holder actually buys, in the case where that scheme's own assets are units of other schemes rather than shares or bonds.. One of the things it holds is the Girnar Broad Market Index Fund, a tracker charging 0.20 per cent of its own assets a year, and that tracker is the inner schemeA scheme held by another scheme. Its charge runs against its own assets, and the holder above it never sees the deduction happen. in every worked figure below. The Girnar Large Cap Equity Fund, an ordinary single layer equity scheme charging 1.65 per cent of its own assets, appears once, purely as something to hold the layered charge up against. Kalyani Bhagat manages the equity scheme and Sohail Merchant heads operations.
Three things are settled elsewhere and are taken as given. Defining a scheme of schemes, and walking through how one is put together, are covered separately. So is the comparison between an exchange traded fund and a scheme of schemes. And so is the expense ratio itself, including the fact that it accrues daily against a scheme's assets rather than being billed to anybody. All of it is assumed here. Cost is not the background of what follows. Cost is the argument.
How many levels does a scheme of schemes actually have?
Three, and the number matters because the holder is present at only one of them. At the top is the holder, who buys and redeems units of the outer scheme and does nothing else. In the middle is the outer scheme, whose assets are units of other schemes. At the bottom are the underlying schemes, each of which holds actual securities and each of which runs its own charge against its own assets.
Consider a rented flat for a moment. A tenant rents from a person who does not hold the building but has themselves taken the whole floor on a lease. The tenant pays one rent to one person, once a month. There are still two agreements in the world, and the person in the middle is paying something on the second one out of what the tenant hands over. The tenant has one counterparty and one payment; the money passes through two agreements before it comes to rest. The holder transacts at one level and pays at two, and the two levels the holder never touches are exactly where the second charge lives.
Which charge is struck on which base?
Each charge is struck on its own scheme's assets, and saying which assets out loud is the discipline that keeps this straight. The baseThe amount a percentage is measured against. The same percentage of different amounts is different money, so a ratio without its base is not a number. of the inner charge is the inner scheme's own assets. The Girnar Broad Market Index Fund charges 0.20 per cent of what the Girnar Broad Market Index Fund holds. The base of the outer charge is the outer scheme's own assets, and those assets are units of the schemes underneath it. The Girnar Multi Scheme Portfolio Fund charges its own percentage of what the Girnar Multi Scheme Portfolio Fund holds.
The two bases are genuinely different, and not one base counted twice. A reader who assumes the outer charge is struck on the securities at the bottom, or that the inner charge is somehow levied on the holder's folio, has misread the shape of the thing even if the rupee answer happens to come out in roughly the same place. Two charges, two parties, two sets of scheme accounts, and each charge struck on assets belonging to the scheme striking it. Nobody is charging anybody twice for the same work. Two different jobs are each being charged for once.
Why do two charges on two different bases still add?
Because of what the outer scheme's assets are made of. The outer scheme's assets are the inner units. When the inner scheme takes its charge against its own assets, the value of those inner units falls by exactly that much. The outer scheme is then holding something slightly smaller, and strikes its own charge on what is left. The subtractions happen one after the other, on the same money, travelling downward.
The arithmetic runs in one line on the case record's own base. Consider a holding of Rs 1,00,000/-. The inner layer at 0.20 per cent of the inner scheme's assets is Rs 200/- for the year. The outer scheme is then left holding Rs 99,800/-. Suppose the outer scheme's own charge were 0.50 per cent of its own assets, a supposition rather than anything the case record contains. The outer layer would then be 0.50 per cent of Rs 99,800/-, or Rs 499/-. Total given up: Rs 699/-. Adding the two headline percentages instead gives 0.70 per cent of Rs 1,00,000/-, or Rs 700/-. To a first approximation the holder's total dragThe reduction in what a holding is worth that comes from charges rather than from what the investments themselves did. is simply the inner charge plus the outer charge, and no rearrangement of the two produces a total smaller than roughly that sum.
The Rs 1/- between Rs 700/- and Rs 699/- is not rounding, and it is worth naming rather than smoothing away. The gap is the second charge being struck after the first has already been taken, so the second charge has a slightly smaller base to work on. The additive Rs 700/- is the honest first approximation, and it is the one a reader can do in their head, so it serves as the working figure throughout. Rs 200/- plus Rs 499/- is Rs 699/- and not Rs 700/-, so the residue appears as a check row below rather than as an equality. Asserting otherwise would teach a small untruth for no gain at all.
The inner charge is struck on the inner scheme's assets and the outer charge on the outer scheme's assets. The two bases are different. So why do the two charges add for the holder?
What does a statement show, and what is missing from it?
A statement shows one scheme. The statement carries the name of the outer scheme, the number of units held, a value per unit, the value of the holding, and the outer scheme's own disclosed chargeThe expense ratio a scheme publishes for itself. The published figure covers that scheme's own charge, and nothing charged inside anything the scheme happens to hold.. Missing from it is any line for the inner scheme's charge, and the reason is worth being exact about.
The inner charge was never a payment out of the holder's folio. The inner charge was taken out of the value of the inner units before the outer scheme used that value to strike its own. By the time any number reaches a statement, the inner charge has already been absorbed into it. There is therefore no row it could occupy, no deduction it could be shown as, and nothing for anyone to have left out. The inner charge is missing from a statement by construction rather than by omission, and a cost that is real, continuous and invisible is a different problem from a cost that is simply high.
Where on a holder's statement does the underlying scheme's charge appear?
Predict before reading on. Two schemes of schemes each hold an underlying scheme charging 0.20 per cent of its own assets. One discloses 0.20 per cent at the outer level and the other discloses 1.00 per cent. In which does the disclosed figure understate the true total by the larger share?
How much does the invisible layer cost on Rs 1,00,000/-?
A percentage of an unstated amount teaches nothing, so price it in rupees. Take the case record's own base of a Rs 1,00,000/- holding for one year. The inner scheme here is the Girnar Broad Market Index Fund, charging 0.20 per cent of its own assets. Do the division rather than reading the answer off: 0.20 divided by 100 is 0.0020, and 0.0020 of Rs 1,00,000/- is Rs 200/-. Rs 200/- is the invisible layer for the year, and it appears on nothing the holder will ever be sent.
Now the outer charge. The case record contains no outer charge, so the shape is worked instead, with three suppositions labelled as such. Suppose the outer scheme disclosed 0.50 per cent of its own assets. The holder would read Rs 500/- and would give up about Rs 700/-, so the figure read understates the total by Rs 200/-, or 28.6 per cent of what is actually paid. At an outer charge of 1.00 per cent the holder reads Rs 1,000/-, gives up about Rs 1,200/-, and the understatement is 16.7 per cent. At an outer charge of 0.20 per cent the holder reads Rs 200/-, gives up about Rs 400/-, and the understatement is fully 50.0 per cent.
| Outer charge, supposed | Read | Paid, additive | Invisible share |
|---|---|---|---|
| 0.20 per cent of the outer scheme's assets | Rs 200/- | Rs 400/- | 50.0 per cent |
| 0.50 per cent of the outer scheme's assets | Rs 500/- | Rs 700/- | 28.6 per cent |
| 1.00 per cent of the outer scheme's assets | Rs 1,000/- | Rs 1,200/- | 16.7 per cent |
| Fixed in every row: the inner layer at 0.20 per cent of the inner scheme's assets | nothing | Rs 200/- | all of it |
| Check on the middle row: Rs 200/- plus 0.50 per cent of Rs 99,800/- | Rs 500/- | Rs 699/- | 28.6 per cent |
The last row is worth attention. The additive Rs 700/- and the struck in order Rs 699/- are not the same number, and the table says so instead of quietly rounding one into the other. The invisible share happens to round to 28.6 per cent on either basis. The additive version is therefore safe to teach. The share of the total that stays invisible is largest when the outer charge is smallest, so a scheme of schemes understates its own cost most severely at exactly the point where it looks cheapest. That is the opposite of what almost everybody expects, and it follows from something very ordinary: a fixed Rs 200/- is a big fraction of a small number and a small fraction of a big one.
A holder has Rs 1,00,000/- in a scheme of schemes whose underlying tracker charges 0.20 per cent of its own assets. What does that layer cost in a year?
What happens to the share that stays invisible as the outer charge rises?
The invisible share falls, and it falls fastest at the cheap end. The invisible amount is fixed at Rs 200/- while the visible amount grows, so the relationship is a curve rather than a line. Look at the left hand end of the shape below: that is where the outer charge is small, and it is where the invisible layer is doing most of the work.
Move the outer charge and watch the invisible share
One control. The outer scheme's charge moves; the inner layer stays fixed at Rs 200/- a year. The left bar is what a holder reads. The right bar is what a holder gives up, and the dark red block at its base is the part that appears nowhere.
At an outer charge of 0.50 per cent of the outer scheme's own assets, a holder of Rs 1,00,000/- reads Rs 500/- a year, gives up about Rs 700/- a year, and 28.6 per cent of what is given up appears on nothing the holder is sent.
Educational illustration. Moving the control changes the figures that follow. The case record contains no outer charge at all, so every value on the control is a supposition. The inner layer is held fixed at the tracker's recorded 0.20 per cent of its own assets, or Rs 200/- a year on a Rs 1,00,000/- holding. The base is one holding of Rs 1,00,000/- for one year, and the paid figure is the additive first approximation described above. Whether the arrangement is worth holding turns on a value for what the second layer buys, and the arithmetic supplies no such value.
How does the invisible layer compare with charges that are already familiar?
A number with nothing to stand against is hard to feel, so set the three amounts side by side on the same base. On a Rs 1,00,000/- holding for one year: the inner layer at 0.20 per cent of the inner scheme's assets is Rs 200/-. The Girnar Large Cap Equity Fund, an ordinary single layer scheme charging 1.65 per cent of its own assets, would cost Rs 1,650/- on the same amount. And the 1.45 percentage point gap between those two charges, 1.65 less 0.20, is worth Rs 1,450/- a year on that base.
So the hidden layer is roughly an eighth of what the active equity scheme's own charge comes to, on the same money, in the same year. The case record prices no benefit on any side of that comparison, so setting three amounts against one another in size settles nothing whatsoever about which arrangement anybody should hold. What the outer scheme's second charge buys is a real thing. The value of that thing is not in the case record and is not in the arithmetic.
The inner layer costs Rs 200/- a year and the Girnar Large Cap Equity Fund's charge costs Rs 1,650/- a year on the same Rs 1,00,000/-. What does that comparison settle?
Who reaches for this arithmetic on a working day?
An analyst comparing two schemes reaches for it first, and the reason is that a comparison is only a comparison if both sides are built the same way. Setting a single layer scheme's disclosed ratio next to a scheme of schemes' disclosed ratio sets a complete number against a partial one. The working habit is to check first whether a scheme holds other schemes at all, and where it does, to go and find what those schemes charge before any comparison is written down. Where the underlying charge cannot be found, the honest entry is that the total is unknown, not the number that happened to be printed.
Sohail Merchant, who heads operations, reaches for it in a different direction. Two sets of scheme accounts are involved, and each charge has to sit against the assets it was struck on, so his question is which pool a given rupee of cost is coming out of. Neither charge is ever collected from a holder, so no folio is touched by either.
A household reaches for it in the plainest way of the three. In deciding where a year of savings sits, the question is not what the disclosed number says, but what the whole thing costs. On Rs 1,00,000/- and a 0.20 per cent inner layer, that is Rs 200/- a year that will never be itemised for anybody, and it recurs for as long as the holding lasts. Saying whether the arrangement is worth its cost needs a price for what the second layer buys, and no such price exists. None of the three can settle the question from the arithmetic alone.
Predict before reading on. The outer scheme moves its money out of one underlying scheme and into another. Did the holder transact?
What does the structure decide about tax, and what does it hand over?
The line here is exact, and getting it exact is more useful than any number would be. The structure decides something mechanical and small: the holder's transactions are purchases and redemptions of the outer scheme's units, and nothing else. The limit on what a holder transacts in is a fact about how the arrangement is built, and it does not move.
The structure does not decide everything a reader actually came for. The classificationThe category a holding is placed in for tax, which decides which set of rules applies to it. The categories and the tests behind them are set in law rather than by a scheme. that applies to those units, the holding periodThe length of time a holding must be held before one set of tax rules applies to a gain rather than another. The lengths are set in law and are revised from time to time. that separates one treatment from another, and the rate applied at the end are all set by the tax authority. The treatment of a scheme that holds other schemes depends on what the scheme holds. The conditions that decide it sit in tax law, and tax law moves and has been changed. Classification, holding period, rate and indexation treatment are all set in law and are revised, and a printed one does not merely become dated when it changes, it becomes wrong. The current position is published at incometaxindia.gov.in, and the scheme conditions at sebi.gov.in.
How is a fund of funds taxed?
What happens when the outer scheme switches between underlying schemes?
Switching worries most readers, and the mechanism is simpler than the worry attached to it. When the outer scheme makes a switchMoving money out of one scheme and into another. Here it is the outer scheme moving its own assets, not the holder moving theirs., it redeems units of one underlying scheme and subscribes to units of another. The outer scheme is dealing in its own assets. The holder places no order, receives no confirmation, pays nothing, and ends the day holding exactly the same number of units of the outer scheme as before.
The holder did not transact, and that is a fact about the structure. Whether that dealing has any consequence at all for the holder's own tax is a separate question, settled in tax law rather than by the shape of the arrangement.
The error that gets made, and what it costs
A reader looks up the expense ratio of a scheme of schemes, sees a low figure, and takes it as what the arrangement costs. Reading that figure is the sensible thing to do. The disclosed ratio is the only figure they have been handed, it is published, and it is correct as far as it goes. The disclosed ratio is also the outer layer alone.
On a Rs 1,00,000/- holding with a 0.20 per cent inner layer, that reader is short by Rs 200/- a year, every year, for as long as the holding lasts. Where the outer figure looks most attractive the shortfall is proportionally worst: at a disclosed 0.20 per cent the reader has missed half the cost. The error costs a comparison against a single layer scheme that was never like for like, plus a cost that stays invisible indefinitely. Nothing in the ordinary run of statements will ever surface it.
The fix is not vigilance, it is a habit. Where a scheme holds other schemes, treat the disclosed figure as the outer layer only. Go and find what the underlying schemes charge. And where that cannot be found, write the total down as unknown rather than as the number that was printed. An unknown total is at least an honest one.
Who fixes the conditions, and where are they read?
The Securities and Exchange Board of India (SEBI) sets the conditions that attach to a scheme holding other schemes, including whether any limit applies to the charges across the layers and what has to be disclosed about them. A limit of that kind exists in the rules. Rules of that kind are revised, and a printed one stops being merely dated and becomes wrong. The current position is published at sebi.gov.in. Industry level disclosure sits with the Association of Mutual Funds in India (AMFI) at amfiindia.com. AMFI publishes that disclosure rather than making any rule.
Everything about tax belongs to the tax authority at incometaxindia.gov.in. Classification, holding periods, rates and the treatment of gains are all set there, they depend on what a scheme holds, and they have been changed. A wrong tax figure is worse than no figure at all, so each of them is read at the source.
What is the trade this structure asks the holder to make?
Both halves of it are real, so name both. On one side, the arrangement buys a single unit to hold instead of several, a single transaction instead of several, one folio instead of several, and reach into schemes a holder might not be able to buy directly at all. The conveniences are genuine, and for some holders they are the whole reason the arrangement exists.
On the other side, it costs a second charge that is certain in direction, invisible on any statement, and of a size this record does not contain. The arithmetic gives a number for the charge, and nothing anywhere gives a number for the convenience, so only one side of that exchange carries a price. A trade with a price on one side and no price on the other cannot be settled by arithmetic. Weighing the two would need a value for what the second layer buys, and no such value exists in this record.
What does this structure ask the holder to exchange?
References
| Source | Document | Where |
|---|---|---|
| Securities and Exchange Board of India | The conditions attaching to a scheme that holds other schemes, including any limit applying across the layers of charge and the disclosure duties that go with them. | sebi.gov.in |
| The tax authority | Classification of a holding, the holding periods that separate one treatment from another, the rates applied and the treatment of gains, all of which depend on what a scheme holds. | incometaxindia.gov.in |
| Association of Mutual Funds in India | Industry level disclosure of scheme charges, published rather than made as a rule | amfiindia.com |
Girnar Asset Management Limited, the Girnar Multi Scheme Portfolio Fund, the Girnar Broad Market Index Fund, the Girnar Large Cap Equity Fund, Kalyani Bhagat and Sohail Merchant are invented.
Educational material. Not advice on any investment, tax, budget or market position.