Fund of Funds: One Scheme That Holds Other Schemes

A fund of funds is a scheme whose holdings are units of other schemes rather than shares or bonds. The holder transacts once, with the outer scheme, and reaches the underlying portfolios through that one holding. Two charges apply, one inside and one outside, and they add rather than cancel. Two questions stay separate: what the outer layer buys, and what it costs.

One difference makes a fund of fundsA scheme whose holdings are units of other schemes rather than shares, bonds or cash instruments held directly. what it is. Notice that it is a single difference and not a list of them. Every pooled scheme holds something. Open the accounts of almost any scheme and the asset side carries securities: shares, bonds, money market instruments, a little cash. Open the accounts of a scheme of schemes and the asset side carries units of a schemeEqual shares of a scheme's assets. A unit is the thing a holder actually holds, and its value is struck each day. instead. Nothing else about the structure changes. The trustee still holds the scheme in trust, the registrar still keeps the records, the day's value is still struck by dividing net assets by units in issue. One substitution on the asset side generates every consequence that follows, including the one about cost that most readers arrive looking for.

Here is a household version of the same substitution, and it is worth holding on to. Suppose ten shopkeepers in a market put money into a common chit and the money buys stock for the market. The first arrangement is an ordinary scheme. Now suppose those ten put money into a common chit, and that chit buys shares of three other chits which each buy stock. Nobody in the first chit deals with any shopkeeper in the other three. The ten deal with their own chit and nothing else, and whatever the other three chits do reaches them through the value of what their own chit holds. The second arrangement is a fund of funds. The reach is longer and the number of hands the money passes through has gone up by one.

Girnar Asset Management Limited, an invented fund house, operates the three schemes that carry every worked figure below. The first is the Girnar Large Cap Equity Fund, an open ended equity scheme managed by Kalyani Bhagat, with net assets of Rs 4,200 crore and 120.00 crore units in issue. Dividing Rs 4,200 crore by 120.00 crore gives Rs 35.00 exactly as the value of one unit. The second is the Girnar Broad Market Index Fund. The tracker follows an unnamed broad index and charges 0.20 per cent of its own assets a year. The third is the scheme of schemes, the Girnar Multi Scheme Fund of Funds. Sohail Merchant heads operations.

What actually sits on the asset side of a fund of funds?

Units of other schemes, and that is the whole definition. There is no second condition and no minimum number of schemes held. A scheme that holds units of one other scheme is already a scheme of schemes; a scheme that holds units of six is the same structure with more rows. The asset side carries claims on other pools rather than claims on companies and borrowers, and that is the whole test. Reading the asset side is reading the structure.

The consequence follows immediately, and it is the consequence to carry everywhere else. Whatever is true of a scheme's assets is true here of the units. A scheme's daily value moves with the prices of what it holds, so the outer schemeThe scheme a holder actually buys into when that scheme's holdings are units of other schemes. moves with the daily values of the schemes it holds, and those move with the prices of what those schemes hold. The chain has one more link than an ordinary scheme, and every effect that follows, cost included, is an effect of that extra link.

How Active Mutual Funds Work, and what changes while the holder does nothing?

Money arrives, units are created for it at the value struck for that day, and the money joins the pool. The scheme publishes a stated mandateThe written statement of what a scheme may hold and how it will be run, which the manager works inside., and Kalyani Bhagat selects what the Girnar Large Cap Equity Fund holds inside it. The holdings are priced every working day and the day's value is struck. The charge of 1.65 per cent a year on net assets of Rs 4,200 crore comes to Rs 69.30 crore across a year, and it runs against the assets a little at a time every single day. None of that machinery is new here; it is settled separately under how an active scheme works.

The part in the middle belongs here. The selection is not a single act performed once when the scheme opened. The selection is a repeated decision, taken again and again for as long as the scheme runs. Because the decision repeats, the portfolio a holder is exposed to changes over time while the holder does absolutely nothing, and that is the moving part a scheme of schemes inherits twice over. A holder who bought units three years ago and never looked again is not holding what they bought. The holder is holding whatever the repeated decision has produced since. The Girnar Large Cap Equity Fund returned 13.4 per cent net of its charges for the stated year in this record. One year and one scheme support no conclusion about active management in either direction.

How Index Funds Work, and why does following a rule still take work?

The holdings are set by the rule of the index the scheme has declared it follows, so nobody selects them. The rule answers the question a manager would otherwise have to answer, so no repeated judgement arises. The whole mechanism is genuinely simpler than the active one above. The Girnar Broad Market Index Fund follows an unnamed broad index and charges 0.20 per cent of its own assets a year.

Now the part that surprises people, and it matters here because a scheme of schemes can hold a tracker. Three things stop this from being a switch left on. The scheme still holds some cash, and cash does not move the way the index moves. The scheme still receives money from buyers and pays money to sellers on days when the index has no such event, so it has to deal simply to stay where it was. And when the index itself changes what it contains, the scheme has to buy and sell to follow. Following a rule is work, not automation, and the combined effect of those three things is measured separately under how closely a tracker follows the index it declares.

How Fund of Funds Work, and what does the holder actually touch?

Money arrives at the outer scheme. The outer scheme uses it to buy units of the underlying schemeA scheme whose units are held by another scheme rather than by a person directly. or schemes it has said it will hold. The underlying schemes then do whatever they do: the tracker follows its index, the active scheme runs its repeated selection. At the end of each working day the underlying schemes strike their own values, and the outer scheme strikes its value from the values of the units it holds. Divide by units in issue and the outer scheme has a value per unit like any other.

The holder touches remarkably little. Look at exactly what. One scheme, one value, one transaction, and no dealing at all in the underlying schemes. The holder never buys units of the tracker. The holder never sells units of the active scheme. The holder cannot instruct the outer scheme to hold less of one and more of another. Nobody added that restriction. The structure produces it. A holder of the Girnar Multi Scheme Fund of Funds transacts with the Girnar Multi Scheme Fund of Funds, and what that scheme holds is that scheme's decision, taken inside its own stated mandate. The single transaction is the convenience and the single point of control is its limit, and they are the same fact seen from two sides.

Why do the two charges add rather than cancel?

Follow the money in the order it actually moves, and the answer stops being surprising. The underlying scheme takes its charge out of its own assets. An expense ratio runs against the pool before the pool is divided into units. So the value of a unit of the underlying scheme is already lower for having been charged. The outer scheme holds precisely those units. The outer scheme then takes its own charge out of its own assets, and its assets are those already reduced units.

Nothing in that sequence pushes back the other way. The second charge is a percentage of whatever is left, and a percentage of a smaller number is smaller in rupees but identical in rate. So the first charge never shrinks the base of the second in any way that offsets it. To a first approximation the holder's dragThe amount by which charges pull a holder's result below what the underlying holdings actually produced. is the inner charge plus the outer charge, and there is no arrangement of the two that makes the total smaller than either one on its own. The smallest the total can be is the inner charge, and that only where the outer charge is nothing at all.

The arithmetic is easier to feel than to read, so here is the same point at wedding scale. A household hires a caterer who takes a fee out of the food budget. The household then hires a coordinator who takes a fee out of what is left of the budget. The coordinator's fee did not come out of the caterer's fee. The coordinator's fee came out of the household's money after the caterer had already been paid. Two fees, one budget, and the household is down by both. The layer structure is exactly that, and the only reason it feels different in a scheme is that neither charge was ever billed to anybody.

What happens to one year's figures when a second layer is added?

Work it on the only inner charge this record contains, and be exact about which parts are figures and which parts are algebra. Take an outer scheme that holds nothing at all except the Girnar Broad Market Index Fund. In the stated year the unnamed broad index returned 12.40 per cent, a figure that carries no costs of any kind because an index is not something anybody holds and nobody pays anything to follow it. The tracker charges 0.20 per cent of its own assets, so a tracker that lost nothing else would have returned 12.20 per cent. The tracker returned 12.12 per cent, a net returnA return measured after the scheme's own charges have already come out of its assets, so no further fee is deducted from it. for the stated year. The shortfall against the index is 12.12 less 12.40, or minus 0.28 percentage points. Of that shortfall, 0.20 is the charge and 0.08 is everything else.

Now add the second layer, and notice how little changes in form. A holder who bought the tracker directly received 12.12 per cent net for the year. A holder who reached the same tracker through the outer scheme received 12.12 per cent less the outer scheme's own charge, for the same year, holding the same underlying portfolio. The second layer is an exact subtraction: the two holders are apart by precisely the outer charge, no more and no less, and the outer holder can never be ahead. The shortfall against the index becomes minus 0.28 points less the outer charge. Both of those statements are exact, and neither of them needs a figure this record does not have.

Put a rupee figure beside it. A percentage point is easy to wave through. 12.12 per cent of Rs 1,00,000/- is Rs 12,120/-, so Rs 1,00,000/- held in the tracker directly for the stated year becomes Rs 1,12,120/-. Reached through the outer scheme, the same Rs 1,00,000/- becomes Rs 1,12,120/- less the outer charge applied to the amount. Suppose an outer charge of 1.00 per cent, purely as a supposition. The figure is Rs 1,11,120/-, lower by Rs 1,000/-, and Rs 1,000/- is exactly 1.00 per cent of Rs 1,00,000/-. The subtraction is not approximately the outer charge. The subtraction is the outer charge.

There remains the half that cannot be resolved. The arithmetic above establishes the direction of the cost and the exactness of it. No price for the access, the single unit or the single transaction appears in this record. The arithmetic therefore says nothing about whether they are worth what they cost. Answering that question would require evidence the record does not hold.

What can this record compute about the total, and what can it not?

Sort it item by item. The sorting is the honest output and not an apology for one. On the computable side: the inner charge is 0.20 per cent of the tracker's own assets a year, the tracker returned 12.12 per cent net for the stated year, and its shortfall against its index was minus 0.28 percentage points, of which 0.20 is charge and 0.08 is cash, flows and index changes. On the other side: the Girnar Multi Scheme Fund of Funds has no charge stated anywhere in this record. Not a range, not an example, not a plausible figure.

The total is therefore not computable here, no figure will be invented for it, and the shape of the answer survives anyway: whatever the outer charge turns out to be, the holder's total is that plus 0.20 points. That is worth more than a made up number, and it is worth saying why. A reader who leaves with a fabricated total will use it. A reader who leaves with the shape will ask a real document what the outer layerOne charging level in a stack. Each layer takes its own charge against its own assets, and a holder in a stack meets all of them. charges, and will then add 0.20 points to whatever the answer is.

What does the second layer actually buy?

Three things, and they are real. The first is access. Some schemes are hard for an ordinary holder to reach directly, whether because of where they are, what they hold or how they are dealt in, and an outer scheme that already holds them turns an awkward purchase into an ordinary one. The second is a mixture reached through a single unit: one holding whose value moves with several underlying portfolios at once, without the holder assembling them. The third is administrative and it is the one people undervalue until they have done the alternative. One transaction instead of several. One statement. One value to read. One thing to sell when the money is needed.

Then comes the discipline, and it belongs here in the body rather than tucked into a caution at the bottom. All three things are genuinely bought, and this record prices none of them. The purchase can be named and the payment can be named; whether the exchange is worth making does not follow from either. Nothing in the case figures says what access is worth to a particular household, and nothing says what one statement instead of four is worth to a person who dislikes paperwork. Both values are real and both are personal. The charge, by contrast, is impersonal and exact. Setting an exact number against an unpriced benefit and declaring a winner would be arithmetic dressed as judgement.

What is a fund of funds not?

Three things, and each of them is a belief somebody arrived with. A scheme of schemes is not automatically a spread of risk. A scheme of schemes holding four schemes may be holding four portfolios with much the same securities inside them, in which case the count of schemes settles nothing at all and the spread is smaller than the number suggests. The spread is settled by what the underlying schemes actually hold, and a count is not that. How a spread of holdings is measured and built is covered separately.

The outer scheme is not a portfolio built for anybody in particular. The outer scheme holds what its own stated mandate says it holds, decided by the people running it, for everybody who buys it. The outer scheme has never met the household holding it, and it does not adjust. The third belief sends most readers to the subject in the first place. A scheme of schemes is not a way of getting round the underlying schemes' charges. The inner charges are not avoided by the structure, they are relocated: taken out of the underlying schemes' own assets, before the outer scheme values a single unit, so they are inside the number the outer scheme starts from. Nothing was skipped. The charge was simply taken somewhere the holder cannot see it.

Girnar Asset Management Limited, the Girnar Large Cap Equity Fund, the Girnar Broad Market Index Fund, the Girnar Multi Scheme Fund of Funds, Kalyani Bhagat and Sohail Merchant are invented.
Educational material. Not advice on any investment, tax, budget or market position.