The Indian investment scenario has seen a significant change over the last three decades. Nowadays, investors have various investment avenues to pursue based on their liquidity situations and risk appetites.
However, no investment avenue is perfect – they all have their advantages and also suffer from disadvantages. Investors must understand the pros and cons of the options available and make wise, informed decisions.
In today’s article, we will be discussing two popular investment options – Exchange Traded Funds (ETFs) and Fund of Funds (FOFs). We will explore their meaning and try to compare them and understand the differences between them.
Let’s dive straight in.
What do you mean by Fund Of Funds (FOFs)?
Fund of Funds (FOFs) refers to a pooled investment fund that invests in other types of funds. They’re also known as multi-manager investment funds. In layman’s terms, the FOF portfolio contains different underlying portfolios of other funds.
FOFs usually invest in other mutual funds and hedge funds. Achieving a broader diversification and minimum risk is the key driver of the FOF strategy. FOFs have higher expense ratios than regular mutual funds.
Different kinds of FOFs act differently in their investment schemes – they may be structured as a mutual fund, a hedge fund, an investment trust fund, or a private equity fund.
What do you mean by Exchange Traded Funds (ETFs)?
Exchange-Traded Funds (ETFs) refer to the type of securities that are essentially a collection of different securities that often track an underlying index. However, ETFs can invest in any industry sector or use various investing strategies.
ETFs are similar to mutual funds and differ when they are listed on stock exchanges, and the ETF shares are traded throughout the day just like any ordinary stock. Hence the name exchange traded funds.
ETFs are marketable securities – they have a price that allows them to be bought and sold in the market. ETF share prices see fluctuations all day as opposed to mutual funds that only trade once a day after market closure. ETFs are more cost-effective and more liquid when compared to mutual funds.
How do Funds of Funds (FOFs) and Exchange-Traded Funds (ETFs) differ from each other?
Now that we have a basic understanding of Funds of Funds (FOFs) and exchange-traded funds (ETFs), let us take a look into the differences between the two:
Differences based on Structure:
FOFs are a basket of mutual funds. Based on their investment objectives and risk profile, FOFs invest in other mutual funds.
ETFs are a basket of securities, just like a mutual fund. They track an underlying index and invest in various securities like stocks and bonds.
Differences based on Liquidity:
The liquidity of FOFs is much lower than that of ETFs because, unlike ETFs, they are not traded.
Unlike mutual funds, ETFs are traded throughout the day on a stock exchange. The trade is similar to that of a stock. Therefore, ETFs have higher liquidity than mutual funds. Consistency in the trading volume of an ETF should be checked before buying.
Differences based on Selling Price:
Since FOFs are a collection of mutual funds, they are traded at the Net Asset Value (NAV), which is calculated at the end of the trading day.
ETFs are marketable securities that are traded on stock exchanges. Therefore, they are bought and sold at the market price, not the Net Asset Value (NAV). ETFs differ significantly from mutual fund schemes because mutual fund units are purchased or sold at their Net Asset Value (NAV). Market forces of demand and supply drive the price of ETFs. The difference between the market price and Net Asset Value (NAV) is usually minimal for the ETFs with high Asset Under Management (AUM) and heavy daily traffic volume.
Differences based on Associated Costs:
FOFs, on the other hand, are actively managed funds. Active management adds costs and increases the expense ratio of FOFs. Investors also bear additional costs when FOFs invest in mutual funds that may charge certain fees.
ETFs are significantly cheaper than FOFs. The expense ratio of an ETF is usually less than 0.5%. This is because ETFs track an underlying index, thereby being passively managed.
Differences based on Tax Liabilities:
Tax is an essential consideration in the choice of investments. Let us look into the tax implications of ETFs and FOFs
Fund of Funds
- Short term capital gains (STCG) on ETFs are chargeable at 15%. This tax liability arises when ETF investments are held for a period that is less than one year.
- Long term capital gains (LTCG) on ETFs up to Rs. 1 lakh are exempt from tax. Long term capital gains (LTCG) beyond Rs. 1 lakh attract a tax liability at the rate of 10% without indexation benefits. LTCG is realized when the ETF investment is held for more than one year.
Gold and other ETFs:
- Short-term capital gains are added to the annual income and taxable according to the applicable income tax slab rates. This tax liability arises when ETF investments are held for a period that is less than three years.
- Long term capital gains are chargeable to tax at the rate of 20% with indexation. This tax liability arises when ETF investments are held for a period that is more than three years.
Fund of funds attracts taxation similar to that of debt funds irrespective of the schemes they invest in – the capital gains arising from investment in equity funds will be treated as a received from debt funds even if the investment was made in equity funds.
- Short-term capital gains are added to the annual income and taxable according to the applicable income tax slab rates. This tax liability arises when FOF investments are held for a period that is less than three years.
- Long term capital gains are chargeable to tax at the rate of 20% with indexation. This tax liability arises when FOF investments are held for a period that is more than three years.
Choosing between an ETF and a FOF?
Now that we’ve discussed the meaning of ETFs and FOFs and looked into the difference between the two, let us discuss few points to keep in mind before investing:
It is prudent to thoroughly go through the scheme documents before investing in an idea about asset allocation and portfolio management strategy.
Investors should have a clear understanding of their financial investment goals, risk tolerance, and the period they plan to invest and accordingly choose to invest.
FOFs provide better diversification because of their investment in different mutual fund schemes managed by expert managers. FOFs pursue other asset classes like asset allocation funds, international funds, ETF FOFs, etc. The investment avenues are many – you just need to be aware of your investment needs.
ETFs provide better long-term returns as they are traded on stock exchanges. ETFs, therefore, is an excellent alternative to stock investments instead of stock trading.
Exchange-Traded Funds are passively managed funds, while seasoned experts manage Funds of Funds. Our discussion above shows that both these investment options are distinct and provide different risk exposure to the investors.
So before you choose which one to invest in, understand your investment objective and whether it aligns with the ETF or FOF and make a wise decision.
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