ETF vs FOF which is better is a common Both Exchange Traded Funds (ETFs) and Fund of Funds (FOFs) are different types of mutual funds that are passively managed. However, these two investments are nowhere similar. While one invests in benchmark indexes, another invests in other funds. This article covers ETF and FOF in detail along with ETF Vs FOF.
What is an Exchange Traded Funds (ETF)?
An Exchange Traded Funds is a type of mutual fund where the investment portfolio tracks the underlying index. In other words, the composition of the ETF portfolio is the same as that of its underlying index. Nifty, Sensex, Bank Nifty, etc., are some examples of ETFs. ETFs can invest across any sector, theme, or investing strategy.
An Exchange Traded Fund merely aims to replicate the index and doesn’t aim to outperform it. Therefore, these are passive investment options. Since ETFs are not actively managed, they have a lower fund management fee.
ETFs trade on the stock exchange, unlike other funds. Hence, their price fluctuates throughout the day. Furthermore, the market price of ETFs is determined by the net asset value of the underlying assets or stocks.
What are the Different Types of ETF Exchange Traded Funds?
Index Fund ETF
Index fund ETFs track a stock market index. For example, Nifty 50, BSE Sensex, etc.
Gold ETF tracks the Gold bullion. Current market prices of gold determine the price of a Gold ETF.
Leveraged ETFs invest in derivatives or debt to boost the returns of an underlying index. These ETFs are currently not available in India.
Bond ETF portfolio comprises bonds that trade in the stock market.
A sector ETF replicated the benchmark index of the chosen sector. In other words, they invest in stocks of a particular sector.
The underlying security of a currency ETF is the currency of one or more countries. Currency ETFs aim to provide exposure to forex currencies. They are useful for hedging forex risks.
Inverse ETFs are made of different derivatives. Investing in an inverse ETF is similar to holding a short position, with an intention to buy back at a lower price. In other words, investors benefit from a decline in the value of the underlying benchmark without actually taking a short position.
Equity ETFs invest in stocks or equity securities of the underlying benchmark index. They purely invest in equities.
Commodity ETFs track commodity indexes that invest in physical commodities or futures contracts. A commodity index can track either one commodity or a combination of commodities. For example, precious metals, agricultural products, etc.
What is Fund of Funds (FOF)?
A Fund of Funds (FoF) is a mutual fund that invests in other funds. In other words, fund of funds invests in mutual funds or hedge funds instead of direct financial securities like stocks, bonds, etc. These funds are diversified and have appropriate asset allocation as their portfolio includes various fund categories.
Fund of funds have varying degrees of risk, and the degree of risk depends on the fund’s objectives. If the fund manager aims for higher returns and yields, then the funds with higher NAV are chosen even though the risk is higher.
Fund of funds invests in both domestic and international funds, increasing the diversification in the portfolio. These funds are managed by highly skilled managers who can make accurate predictions and minimize the chance of losses.
There are different types of fund of funds, namely asset allocation funds, gold funds, international fund of funds, multi-manager funds and ETF fund of funds.
Asset Allocation Funds
These funds have a diverse pool of assets, increasing the chance of generating high returns and minimizing the risk through diversification. They invest in equity, debt, metals, commodities, etc.
Gold fund of funds invests in gold mutual funds or in companies trading in gold. AMC and fund managers decide the portfolio of these funds.
International Fund of Funds
These funds invest in mutual funds in a foreign country. This not only helps diversify the portfolio but also earn high returns from the best performing securities in that country.
Multi-Manager Fund of Funds
These funds are quite common and have a portfolio of professionally managed mutual funds, each having a different portfolio concentration. This type of fund has different portfolio managers for different asset classes.
ETF Fund of Funds
These are mutual funds that invest in ETFs. They are more accessible to invest than direct ETFs as direct ETF investment requires a demat account. Whereas investing in fund of funds ETFs doesn’t require a demat account. These funds are slightly more volatile than the rest as ETFs trade on the stock exchange.
Difference Between Exchange Traded Funds and Fund of Funds
here are some points of difference between ETF vs FOF.
ETFs are passive investment options that comprise securities similar to a mutual fund. ETFs replicate the composition of the underlying index. Furthermore, they aim to earn benchmark returns and do not aim to beat them.
On the other hand, FOF is a multi-manager investment. Instead of investing directly in stocks, bonds, or other securities, a fund manager creates a mutual fund portfolio. FOFs have an underlying fund that is either from the same fund house or from different fund houses. FOFs aim to achieve diversification and good asset allocation by investing across different funds in various categories.
ETFs trade on the stock exchange and hence are highly liquid. They are comparatively more liquid than mutual funds. Trading volumes of the ETF can be tracked easily.
On the other hand, FOFs have low liquidity in comparison to ETFs.
Similar to shares or stocks, ETFs are marketable instruments that actively trade on the stock market. Hence, their price fluctuates throughout the day. The market price of ETFs is determined by the net asset value of the underlying assets or stocks. Therefore like mutual funds, buying and selling of an ETF are not done at the NAV. Often the difference between the Net Asset Value (NAV) and the market price of the ETF is low.
On the other hand, FOFs are traded at their Net Asset Value (NAV). The NAV of the fund is determined at the end of the trading day.
ETFs have a low expense ratio, however, there are other costs involved. Buying and selling of ETFs take place on a stock exchange. Therefore, each transaction necessitates the payment of brokerage to the broker. There is also the securities transaction tax, the difference between the ask and bid spread, and other additional costs associated with stock trading.
Like other mutual funds, FOFs also incur expenses. However, the expenses a FOF incurs are higher than other regular funds. In addition to the regular management and administrative fees, there are expenses related to underlying assets. Although FOF’s expense ratio is 1%, investors are required to pay this amount on every fund that the FOF holds.
An ETF can either hold stocks belonging to one sector or industry or own stocks across different sectors. The different types of ETFs are Index Fund ETF, Gold ETF, Leveraged ETF, Bond ETF, Sector ETF, Currency ETF, Inverse ETF, Equity ETFs, and Commodity ETFs.
On the other hand, the different types of FOFs are Asset Allocation Funds, International Fund of Funds, Gold Funds and Multi-Manager Fund of Funds.
Taxation of ETFs depends on the type of ETF. Equity ETFs are taxed similarly to equity mutual funds. Short-term capital gains taxes (STCG) of 15% + 4% Cess apply to investments with a holding period of less than one year. Long-term capital gains taxes (LTCG) of 10% for gains above INR 1,00,000 apply to investments having a holding period of more than one year.
On the other hand, taxation of Gold ETFs and other non-equity ETFs is similar to debt mutual funds. Short Term Capital Gains (STCG) tax is applicable to investments held for less than three years. The profits are taxable at the investor’s income tax slab rate. For investments with a holding period greater than three years are subject to Long Term Capital Gains (LTCG) tax of 10% without indexation benefit and at 20% with indexation benefit.
Despite the fact that FOFs invest in equity mutual funds, their taxation is similar to debt funds. The investor is only taxed when they redeem their investment from the FOF. When the fund manager is actively managing the fund by buying and selling the units of the fund, the investor is not obligated to pay tax.
FOFs also attract Dividend Distribution Tax for their domestic equity investments. The FOFs attract dual DDT. The dual DDT occurs when corporations pay dividends to their shareholders and when the FOF pays dividends to its unitholders.
How to Choose Between ETF vs FOF?
The choice between ETF vs FOF depends on multiple factors.
Investors always look for high returns. However, one must understand that returns and risk go hand in hand. An investor looking for higher returns should be willing to take higher risks. Also, a more volatile investment should compensate investors with high returns. Hence investors have to ensure they do thorough research and understand the portfolio, asset allocation and strategy before deciding to invest in it. In the case of ETFs and FOFs, investors have to ensure they understand the investment before investing in it.
One investment never suits two individuals in the same way. Every investor has to understand their profile and pick the investments that suit them well. The three pillars to an investment profile are investor goals, risk tolerance level, and investment horizon. Every investor has to ensure their investments are in line with these three pillars. That is when the investor will be able to reap maximum benefits from the investment. Hence while choosing an ETF or FOF, they have to ensure these three pillars of the investor profile are taken into consideration.
Experts always say diversification will help reduce the risk in the portfolio. Hence investors have to put their investments in multiple asset classes. FOFs are more diversified than ETFs as they invest in multiple mutual funds. Moreover, they also offer professional management as there are multiple fund managers who are highly skilled in managing the portfolio of FOFs. If an investor is looking for diversification, FOFs can be considered.
Suppose an investor wants to invest in stocks but lacks the time and knowledge to do so. In that case, they can consider ETFs as a great alternative to stock investing. ETFs trade on the stock exchange similar shares. Investors who want to gain knowledge on stock investing can try it by investing in ETFs.
Though both ETFs and FOFs are passively managed, they are different from each other. Understand the differences between the two before making a choice. Also, while choosing between ETF vs FOF, investors have to ensure their profile aligns with the investment’s objectives. Always choose the investment which will help reach one’s financial goals.