ETF vs. Fund of Funds (FoF): Understanding the Key Differences

There has been a huge paradigm shift in the country’s investment ecosystem. With more awareness about the stock market, the share of investors has increased significantly. Mutual funds are one of the very common investment options chosen. This article talks about two other popular investment funds: Exchange Traded Funds and Fund of Funds. 

Exchange-Traded Funds (ETF)

An Exchange Traded Fund is a basket or portfolio of diversified stocks similar to a mutual fund. But, unlike mutual funds, ETFs can be traded on the exchange. These are usually preferred by people who are looking to trade open-ended funds on the stock exchange. So, ETFs are comparatively more liquid than mutual funds. The majority of the ETFs (85%) track the equity index. 

Fund of Funds (FOF)

Fund of funds like the name defines is a fund that invests in various diverse mutual fund schemes. The portfolio can contain schemes from the same or different fund houses. They are usually personalized catering to the risk appetite and investment goal of the investors. These funds can also include international schemes. 

ETFs Vs FOFs – A Comparative

Parameter Exchange Traded Funds Fund of Funds 

• Basic Structure

Basket of stocks, bonds, or other securities. Basically, a portfolio of diversified securities tracking an index. Basket of diversified mutual funds. A portfolio of funds catering to investors’ risk appetite and objectives.

• Price

No NAV for ETFs. Since they are similar to stocks, ETFs are traded at market prices. Although there’s a catch – ETFs with high assets under management and high trading volume have their market price closer to their NAV. As FOFs are a basket of mutual funds and are not traded on the stock exchange, FOFs are traded at their Net Asset Value (NAV), which is calculated at the closing time of trading day. 

• Liquidity

Can be traded just like any other stock on the stock exchange. So, higher liquidity than a normal mutual fund. Trading volume is a key indicator of the liquidity of ETFs in the market Low liquidity. Since Fund of Funds cannot be traded actively like ETFs, their liquidity is low. 

• Costs

Cheaper than mutual funds as they are traded and passively managed. The expense ratio is usually less than 0.5% FOFs are a bit costly as these are actively managed funds. The management cost and the portfolio mutual funds fee to the FOF might also get passed to the investor. 

• Taxes 

The taxation is different for different ETFs, which are Equity ETFs, Gold ETFs, and others.  Despite the mutual funds (equity or debt) in the portfolio of FOFs, these are taxed like debt funds. 

Taxation of ETFs and FOFs in detail

ETFs

• Tax implications for Equity Exchange Traded Funds

Tax implications are dependent on the number of years an investor holds the ETFs. If the holding period is less than 1 year,  any capital gains earned through the ETF  will be considered short-term capital gains (STCG)  and the tax liability would be 15%. But if the holding period is more than one year,  then the capital gains are considered Long-Term Capital Gains (LTCG).  LTCG up to INR 1 lakh is exempted from tax.  For an amount greater than INR 1 lakh,  the tax would be 10% without any indexation benefits.

• Tax implications for Gold & Other Exchange Traded Funds 

The capital gains are considered as short-term capital gains (STCG) if the fund was held for less than 3 years by the investor.  Short-term capital gains would be added to your annual income and will be taxed as per the applicable income tax rate. Long-term capital gains are the ones where the fund was held for more than 3 years. In this case, the capital gains would be taxed at 20%  along with the indexation benefits.

FOFs

If the fund was held for less than three years, the earnings are considered short-term capital gains that are added to your annual income and would be taxed as per the applicable income tax rates. If the fund is held for more than three years,  the earnings are considered long-term capital gains and are taxed at 20% along with indexation benefits.

Wrapping up

Always choose investment options based on your risk appetite, financial goals, and investment time period.  Build a portfolio that is aligned with your investment goals. ETFs and FOFs are funds that are passively managed and are great options for investors. Both of these are generally better long-term investment options. Despite all the advantages and disadvantages, we have discussed in this article, it is very important for investors to understand whether ETFs and FOFs fundamentally align with their goals before making any sort of investment decision.