Investing in a Fund of Funds: Taxation Treatment of FOF

According to Investopedia, A Fund of Funds (FOF) - also referred to as a multi-manager investment - is an investment strategy in which a fund invests in other types of funds. This strategy invests in a portfolio that contains different underlying assets instead of investing directly in bonds, stocks and other types of securities. The versatility offered by this fund is akin to a cricketer who is able to bat anywhere in the order.
A Fund of Funds helps ease risk to a large extent by distributing investment across different funds.A Fund of Funds lowers the risk level of investments by investing fund in different kind of mutual funds. The taxation treatment of the fund is admittedly less than ideal.
Broadly, equity and debt are the two major areas of investments in the mutual fund industry. Both of them are taxed differently. All equity funds are in one tax bracket and all non-equity funds are in another tax bracket. Surprisingly, an equity fund of funds – which has equity funds as a part of its portfolio – is taxed as a non-equity fund!

Note the taxation differences in the table below:

An Equity-oriented fund, taxed as a debt fund

Taxation and investment go hand-in-hand. While considering investment opportunities, the first challenge that almost every investor faces is choosing among a plethora of options. The investor is also tasked with determining which of the options would be the most tax efficient. Equity Funds invest heavily in equities, which usually exceed 65% of their portfolio allocation. A Fund of Funds is a perfect combination of growth and diversification. The fund is eligible to classify as an equity fund as it invests only in the equity market. However, in reality, a Fund of Funds is taxed as a debt fund.
The mutual fund industry has argued that an equity fund of funds invests only in equities and thus such funds deserve the same tax rules that are applicable to all other equity funds.
The difference in opinion between the tax department and the mutual fund industry will hopefully end on a positive note for the industry. However, until such time, investors should consider a Fund of Funds as a good option for long-term investment, as can be seen from the performance of the Quantum Equity Fund of Funds:

For other Schemes Managed by Mr. Chirag Mehta please click here.
A drawback of Fund of Funds is that an investor must pay the FoF manager a fee in addition to the fees charged by individual funds. But if one trusts the investment process followed by the FoF manager to astutely consider the fees of the funds in which it invests, then the additional fee paid for the FoF can be well worth it. Note that despite this additional layer of fees (which at Quantum is one of the lowest in the industry), the Quantum Equity Fund of Funds has outperformed its benchmark over the last three years.
Do not forget, equities have the potential to give the better  post-tax returns over the long term . Selecting the best funds and remaining invested for the long term is the only mantra for successful investors.

Name of the Scheme & Primary Benchmark	This product is suitable for investors who are seeking*	Risk-o-meter of Scheme
Quantum Equity Fund of Funds An Open Ended Fund of Funds scheme Investing in Open Ended Diversified Equity Schemes of Mutual Funds	• Long term capital appreciation • Investments in portfolio of open-ended diversified equity schemes of mutual funds registered with SEBI whose underlying investments are in equity and equity related securities of diversified companies	Investors understand that their principal will be at Very High Risk

Above article is authored by Quantum.

View All