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Over the last three decades, there has been a huge change in the Indian investment landscape. While most of the investment options offer certain pros and cons, understanding their features is important to make an informed decision. Today, we are going to talk about two popular investment options – ETFs and FOFs and compare the differences between them.

What is an ETF?

An Exchange Traded Fund or ETF is a basket of diversified securities like a mutual fund. The difference is that unlike other mutual funds, an ETF can be traded on the stock exchange. They are preferred by investors who are looking at open-ended mutual funds that can be traded on the exchange throughout the day at a value close to that of the underlying assets. This makes ETFs more liquid than mutual funds. Most ETFs track an index – nearly 85% of ETFs track an equity index.

What is FOF?

While a mutual fund invests in securities like stocks, bonds, etc., a Fund of Funds or FOF is a mutual fund that invests in other MF schemes. These schemes can be from the same fund house or different ones. It is designed to cater to the investment requirements of people with varying risk tolerances and investment goals. FOFs can be international too. 

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ETF vs. FOF – The Comparison

Here is a look at the similarities and differences between ETFs and FOFs:

1. Structure

  • ETFs are a portfolio of securities just like a mutual fund. While most of the track an index, they invest in securities like stocks, bonds, etc. 
  • FOFs are a basket of mutual funds. They invest in other mutual funds as per their investment objective and risk profile.

2. Liquidity

  • ETFs can be traded throughout the day on a stock exchange just like a stock. Hence, it has higher liquidity than mutual funds. While the liquidity depends on the demand in the market, investors must look for consistency in the trading volume of an ETF before buying.
  • Since FOFs cannot be traded like ETFs, the liquidity is much lower. 

3. Selling Price

  • Since ETFs are traded on a stock exchange, they are bought or sold at the market price and NOT the NAV. This is a huge difference because all mutual fund schemes are purchased or sold at their Net Asset Value (NAV). The market price of an ETF is determined by its demand and supply. Usually, ETFs with high AUMs (Assets Under Management) and heavy trading volumes (daily) have a minimal difference between the market price and NAV.
  • FOFs are traded at the NAV calculated at the end of the trading day. 

4. Costs

If we compare costs, then ETFs are much cheaper than FOFs. Usually, the expense ratio of an ETF is less than 0.5% since most ETFs are passively managed as they track an index. On the other hand, FOFs are actively managed funds. Therefore, the fund management cost is added to the expense ratio. Additionally, the mutual funds that the FOF invest in may charge certain fees that are passed on to the investor as well.

5. Taxation

Tax is an important aspect while choosing investments. The tax implications of ETFs and FOFs are as follows:

ETF Taxation

From a tax perspective, ETFs are of three types – equity, gold, and others. Here are the tax implications:

Equity ETFs

  • If the ETF has been held by you for less than one year, then the capital gains earned will be termed as short-term capital gains or STCG. The tax liability will be 15%.
  • If the ETF has been held by you for more than one year, then the capital gains earned will be termed as long-term capital gains or LTCG. LTCG up to Rs.1 lakh is exempt from tax. The tax liability of LTCG above Rs.1 lakh will be 10% without indexation benefits.

Gold and Other ETFs

  • If the ETF has been held by you for less than three years, then the capital gains earned will be termed as short-term capital gains or STCG. The capital gains will be added to your annual income and taxed as per the applicable income tax slab rates.
  • If the ETF has been held by you for more than three years, then the capital gains earned will be termed as long-term capital gains or LTCG. These capital gains will be taxed at 20% with indexation benefits.

FOF Taxation

All Fund of Funds are taxed as debt funds regardless of the schemes they invest in. This means that even if the FOF is investing in equity-oriented funds, the capital gains arising from investing in it will receive the tax treatment of a debt fund. This is as follows:

  • If the FOF has been held by you for less than three years, then the capital gains earned will be termed as short-term capital gains or STCG. These capital gains will be added to your annual income and taxed as per the applicable income tax slab rates.
  • If the ETF has been held by you for more than three years, then the capital gains earned will be termed as long-term capital gains or LTCG. These capital gains will be taxed at 20% with indexation benefits.

How to Choose Between an ETF and FOF as an Investor?

When you are looking at investment options, there are a few things that you must keep in mind:

  1. Returns on investments are directly proportional to risks. Hence, if an investment has a higher risk, then it must offer a better opportunity to earn higher returns. However, while following this rule, ensure that you understand the investment avenue well. In the case of ETFs and FOF, go through the scheme documents and look at the asset allocation strategy and portfolio composition carefully.
  2. Choose investments based on your investor profile. There are three pillars of an investor profile – financial goals, the tolerance to risks, and the period for which you want to stay invested. As long as your investments are in tune with these three aspects, your portfolio will work well for you. To give you an example, if an investor with a high tolerance for risk invests in an ETF that tracks the Nifty 50, then the returns will not be as per his expectations. Such investors should opt for high-risk investments like mid-cap or small-cap funds, etc.
  3. FOF’s offer a unique option of diversification by investing in other mutual funds. Hence, you can benefit from the experience and expertise of multiple fund managers. FOFs are available in different variants like asset allocation funds, gold funds, international funds, ETF FOFs, etc. Ensure that you choose based on what your investment portfolio needs.
  4. While ETFs can be traded on the stock exchange, they tend to offer better returns over the long-term. Hence, they are a great alternative for stock investments and NOT stock trading.
  5. Both ETFs and FOFs are passively managed. Hence, they are ideal for investors looking for investment avenues that are not actively managed. 

Summing Up

ETFs are passively managed funds, on the other hand, FOFs are mutual funds designed to cater to the needs of investors who prefer actively-managed funds. However, as you can see above, there are many differences between the two. Hence, it is important to understand these differences before making a decision.

Happy Investing!

Disclaimer: This blog has been contributed by the content desk of  Sundaram Mutual Fund AMC. The views expressed here are of the author and do not reflect those of Groww.

Investment in securities market are subject to market risks, read all the related documents carefully before investing. Please read the Risk Disclosure documents carefully before investing in Equity Shares, Derivatives, Mutual fund, and/or other instruments traded on the Stock Exchanges. As investments are subject to market risks and price fluctuation risk, there is no assurance or guarantee that the investment objectives shall be achieved. NBT do not guarantee any assured returns on any investments. Past performance of securities/instruments is not indicative of their future performance.

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