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When it comes to investing, countless options are available, and choosing the right one can be overwhelming. Two popular choices that often confuse investors are Exchange Traded Funds (ETFs) and Fund of Funds (FOFs). While both offer diversification and professional management, they work differently and serve different investment goals.
If you’re trying to decide between ETFs and FOFs, this guide will break down their key differences, benefits and potential drawbacks helping you make an informed decision that aligns with your financial goals.
If you’ve been exploring mutual funds, you might have come across the term “FoF” and wondered what it means. Fund of Funds or FoF is a type of mutual fund that invests in other mutual funds or ETFs instead of directly holding stocks, bonds or other securities.
One of the biggest advantages of FoFs is that they offer exposure to multiple funds, reducing the risk associated with investing in a single asset. Another benefit is professional management fund managers handle asset allocation, fund selection and rebalancing to ensure an optimized investment mix. Some FoFs provide access to specialized or global markets that may not be easily reachable for individual investors.
Exchange traded funds or ETFs are investment funds that trade on stock exchanges, just like stocks. They are designed to track the performance of a specific index, sector, commodity or mix of assets. By investing in an ETF, you get exposure to multiple securities in one go, making diversification simple and cost effective.
One of the biggest advantages of ETFs is that they can be bought and sold throughout the trading day at market prices, unlike mutual funds which are only traded at the end of the day. ETFs also come with lower expense ratios, making them a cost efficient investment option. Since ETFs trade on exchanges, they offer high liquidity allowing investors to enter or exit positions with ease.
Another key benefit is transparency. ETF holdings are regularly disclosed, so you always know what you’re investing in. Whether you are a beginner looking for a simple way to start investing or an experienced trader seeking short term opportunities, ETFs provide flexibility to match different investment strategies.
Now you know what FoF means, it is time to explore the differences between ETF and FoF.
Differences Between ETF and FOF
To clearly understand the differences between ETFs and Fund of Funds, let’s explore their key characteristics.
| Basis | Exchange Traded Funds (ETFs) | Fund of Funds (FOFs) |
|---|---|---|
|
Trading |
ETFs are traded on stock exchanges throughout the day and can be bought and sold just like stocks, offering intraday liquidity. |
FoFs are traded at the end-of-day NAV, with transactions processed after the market closes. Unlike ETFs, which can be bought and sold throughout the trading day, liquidity in FoFs is only available at the end of the trading session.
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|
Management
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ETFs are passively managed, tracking an index with lower management fees. However, they offer limited flexibility as they follow the index rather than actively selecting securities. |
FoFs are actively managed by fund managers, leading to higher management fees but offering greater flexibility in selecting underlying funds for a well diversified portfolio. |
|
Investment
|
ETFs invest directly in stocks, bonds or other securities, providing transparency with holdings that are updated daily. often tracking a specific index or sector. |
FoF invests in other mutual funds or ETFs rather than directly in stocks or bonds. Its holdings may be less transparent, as updates are provided periodically instead of in real time.
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|
Cost
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ETFs have lower expense ratios, but they may include brokerage fees. Unlike FoFs, they don’t have additional management fees beyond the expense ratio.
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FoFs have higher expense ratios due to layered fees, no brokerage costs but possible entry/exit loads, and additional management fees for underlying funds.
|
Taxation of ETFs and FOFs
Understanding the tax implications is crucial when comparing an ETF and FoF. Let’s have a look into the taxation aspects of both investment vehicles in the Indian context.
ETFs
The taxation of ETFs in India depends on the underlying assets and the holding period:
1. Equity ETFs:
- Short term capital gains (held for less than 12 months): Taxed at 20%
- Long term capital gains (held for more than 12 months): Taxed at 12.5% for gains exceeding Rs. 1 lakh per financial year
- LTCG exemption limit has increased from ₹1 lakh to ₹1.25 lakh per financial year.
2. Gold and Debt ETFs:
- Short-term capital gains (held for under 36 months) are taxed based on the investor's income tax slab, while long term gains (held beyond 36 months) are taxed at 20% with indexation benefits.
FOFs
FoF taxation in India is slightly different from regular mutual funds:
1. Equity FOFs:
- Short term capital gains (held for less than 12 months): Taxed at 20%
- Long term capital gains (held for more than 12 months): Taxed at 12.5% for gains exceeding Rs. 1 lakh per financial year
- LTCG exemption limit has increased from ₹1 lakh to ₹1.25 lakh per financial year.
2. Debt FOFs:
- Follows the same taxation rules as debt funds
- Short term capital gains (held for less than 24 months): Taxed as per the investor’s income tax slab.
- Long term capital gains (held for more than 24 months): Taxed at 12.5% with indexation benefits
3. International FOFs:
- Treated as debt funds for taxation purposes
- Follow the same taxation rules as debt FOFs
Dividends are no longer subject to distribution tax, instead, investors pay tax on them based on their tax slab.
Which one should you choose between ETFs vs FOFs?
Choosing between an ETF vs fund of funds depends on your investment goals, risk tolerance and strategy. Here are key factors to consider:
- Investment Objective: If you prefer tracking a specific index or sector, ETFs may be a better fit. For broader diversification across multiple funds, FoFs could be a more suitable option.
- Trading Flexibility: ETFs allow intraday trading, making them ideal for those who want flexibility. FoFs are suited for longterm investors who do not require frequent trading.
- Costs: ETFs generally have lower expense ratios, making them cost efficient. However, frequent trading may involve brokerage fees, whereas FoFs might have entry or exit loads.
- Diversification: Both offer diversification but FoFs provide exposure to a wider range of assets and strategies through multiple underlying funds.
- Tax Efficiency: ETFs tend to be more tax efficient due to their structure, while FoFs may incur higher tax liabilities due to the turnover of underlying funds.
- Management Style: ETFs are mostly passive investments, ideal for hands off investors. FoFs offer professional fund selection and asset allocation, making them appealing to those seeking active management.
Final Words
When it comes to FoF vs ETF both bring distinct advantages to an investment portfolio. ETFs stand out for their cost effectiveness, trading flexibility and tax efficiency making them ideal for passive investing and targeted market exposure. FoFs provide enhanced diversification, expert fund management and access to specialized investment strategies making them a suitable choice for investors seeking a well structured and diversified approach across various asset classes.
Frequently Asked Questions
What is the FOF ETF Fund?
An FOF ETF is an exchange traded fund that invests in other ETFs instead of individual securities. It combines the trading flexibility of ETFs with the diversification benefits of FoFs providing exposure to multiple ETFs in a single investment.
Which is better, Fund of Funds or ETF?
The choice between FoF and ETF depends on your investment style. ETFs offer lower costs and intraday trading, ideal for cost sensitive and index investors. FoFs provide broader diversification and professional management, suited for passive multi asset investing.
What are the types of FOF?
Fund of Funds offer diverse investment approaches. Equity FOFs focus on equity oriented mutual funds, Debt FOFs on debt focused funds and Balanced FOFs combine both equity and debt funds.
Does ETF pay dividends?
Yes, many ETFs pay dividends based on their holdings. Equity ETFs distribute stock dividends, while bond ETFs pay interest. Some ETFs reinvest dividends, while others pass them to investors.
Happy investing and thank you for reading!
Disclaimer:
This website content is only for educational purposes, not investment advice. Before making any investment, it’s important to do your own research and be fully informed. Investing in the stock market includes risks, and you should carefully read the Risk Disclosure documents before proceeding. Please remember that past performance doesn’t guarantee future results, and due to market fluctuations, your investment goals may not always be achieved.
