International FoF Mutual Funds: Currency Risk, Hedging & Taxation

What Is an International Fund-of-Funds (FoF)?

An International Fund-of-Funds (FoF) is a mutual fund that invests in one or more overseas mutual funds instead of investing directly in international securities. The underlying funds may invest across global equities, debt instruments, sectors, regions, or investment themes.

Investors purchase units of the domestic FoF, while the fund invests in international mutual funds on their behalf. As a result, the investment value may be influenced by both the performance of the underlying funds and movements in foreign exchange rates. The extent of international exposure depends on the scheme's investment objective.

The Three Types of Currency Risk Investors Face

Currency movements may influence international investments in different ways. The following are the three main types of currency risk associated with international FoFs:

• Exchange Rate Risk: Changes in the value of the Indian Rupee against foreign currencies may increase or reduce investment returns.
• Translation Risk: The value of overseas investments changes when converted into Indian Rupees for reporting and valuation.
• Economic Risk: Long-term currency movements may influence overseas economies, companies, and markets, which may indirectly affect fund performance.

How Do Fund Managers Hedge Currency Risk?

Fund managers may use different approaches to reduce the impact of exchange rate fluctuations on the portfolio. The strategy followed depends on the scheme's investment objective and hedging policy.

The following are some commonly used methods:

• Use currency derivatives, such as forward contracts, to manage exchange rate movements.
• Hedge only a portion of the portfolio instead of the entire investment.
• Adjust hedge levels based on market conditions and portfolio requirements.
• Review and rebalance hedge positions periodically.

Some schemes hedge a significant part of their currency exposure, while others remain largely unhedged. Investors may review the Scheme Information Document (SID) to understand the approach followed by a particular scheme

Hedged vs Unhedged Funds: The Trade-Offs

The following table compares the two approaches.

Hedging may reduce the impact of currency fluctuations, but it also involves additional costs. Unhedged funds remain exposed to currency movements, which may either increase or reduce returns. Therefore, both approaches may be reviewed along with the scheme's investment objective and overall investment strategy.

Cost of Hedging: What Eats Your Returns?

The following factors may contribute to the cost of currency hedging:

• Charges associated with derivative contracts.
• Interest rate differences between countries.
• Transaction and operational expenses.
• Cost of renewing hedge contracts.
• Market conditions affecting hedging prices.

Hedging does not remove investment risk and may increase the overall cost of managing the portfolio. The impact differs across schemes depending on the extent of hedging and prevailing market conditions.

When Does Hedging Make Sense for an Indian Investor?

The usefulness of currency hedging depends on the investment objective and prevailing market conditions. The following are some situations where investors may review hedged international FoFs:

• When exchange rate volatility is relatively high.
• When reducing the impact of currency fluctuations is an investment consideration.
• When the focus is primarily on overseas market performance rather than currency exposure.
• When investors prefer relatively lower currency-related fluctuations within the portfolio.

The approach followed by each scheme may differ. Investors may therefore review the fund's hedging policy before investing.
 

Regulatory & Operational Notes for India

International FoFs operate under the regulatory framework prescribed by the Securities and Exchange Board of India (SEBI). These schemes are also subject to overseas investment limits and disclosure requirements applicable to mutual funds investing outside India.

Investors may review the Scheme Information Document (SID), portfolio disclosures, expense ratio, investment objective, and currency hedging policy before investing. Regulatory requirements and overseas investment limits may change over time, and fund houses update their disclosures accordingly.

Taxation of International FoFs

The taxation of international Fund-of-Funds (FoFs) depends on the fund structure, investment date, and applicable tax provisions. International FoFs are generally treated as non-equity mutual funds unless they qualify for equity-oriented fund taxation under applicable rules.

For specified mutual funds covered under Section 50AA of the Income Tax Act, units acquired on or after 1 April 2023 are treated as short-term capital assets, irrespective of the holding period. Gains from such units are taxed according to the investor’s applicable income tax slab rate.

From FY 2025-26, a specified mutual fund includes a fund that invests more than 65% of its total proceeds in debt and money market instruments or a fund investing 65% or more in units of such funds.

The following table explains the general taxation structure:

Investors should review the scheme structure, underlying investments, and applicable tax provisions before redeeming international FoF units. Since tax rules may change over time, investors may refer to the latest regulations or consult a qualified tax adviser. 

Practical Checklist for Investors

The following checklist may help investors compare international FoFs before investing:

• Review the investment objective and underlying fund.
• Check whether the scheme follows a hedged or unhedged strategy.
• Understand the level of currency exposure.
• Compare the expense ratio and applicable costs.
• Review the taxation rules applicable to the investment.
• Read the Scheme Information Document (SID) and Key Information Memorandum (KIM).
• Compare similar international FoFs.
• Review whether the scheme aligns with the intended investment horizon and overall asset allocation.

Conclusion

International Fund-of-Funds (FoFs) provide access to overseas markets while introducing additional considerations such as currency movements, hedging practices, taxation, and regulatory requirements. These factors may influence investment outcomes differently across schemes. Investors may therefore review the investment objective, hedging policy, underlying portfolio, costs, and applicable tax rules before comparing international FoFs. Reviewing the available scheme documents alongside these factors may provide a broader understanding of how different international FoFs operate.