A Comprehensive Guide on the ETF vs FOF

Table of Contents

Exchange-traded funds (ETF) and (FOF) funds of funds are passively managed mutual funds. However, both of them are quite different from each other. ETF replicates a benchmark index, whereas FOF invests in other funds.

Continue reading to know the differences between these two investment options!

What Are Exchange Traded Funds?

These funds track and follow a particular benchmark index. They can invest in multiple asset classes like gold, currencies, stocks, bonds, etc. Fund managers of ETFs create a portfolio based on the underlying index. The composition and weightage given to each stock are directly proportionate to the index that the fund is tracking. ETFs replicate a few indices like Sensex, Nifty 50, and Bank Nifty.

One of the biggest features of this fund is that they are tradable on stock exchanges just like any share. Therefore, their price fluctuates during every trading session.

What Are Fund of Funds?

A Fund of funds is another type of mutual fund. These funds do not invest in securities like stocks and bonds directly – they invest in units of other mutual funds. That’s why they are also called multi-manager funds. FOF is a passive investment vehicle wherein the fund manager buys mutual fund units according to the mutual fund scheme’s objective.

The performance of the funds is completely dependent on how the other mutual funds are performing. Thus, fund managers of FOFs do not play an active role in the final yield that these funds generate.

FOF vs. ETF

Here, we will discuss the differences between the two funds:

Parameter	FOF	ETF
Structure	A fund of funds invests in other mutual fund units. They can invest in domestic and foreign funds to increase diversification in their portfolio.	On the other hand, ETFs track a particular benchmark index and create their portfolio according to the index they follow. Fund managers invest in the securities that constitute the underlying benchmark index.
Price	The purchase and sale of FOF units occur at their Net Asset Value (NAV). It is decided after the closing of the trading session every day. You cannot trade units of fund of funds, unlike an ETF.	Units of exchange-traded funds are tradable like any other shares on stock exchanges. Their NAV fluctuates as per the value of the underlying assets.
Cost	The cost associated with these funds is quite high. They come with an expense ratio that investors have to pay to every fund house whose units FOFs are holding. This leads to a multiplication of costs.	These funds come with a lower expense ratio. The fund management fee is low as the ETFs are passively managed. As units of ETFs are tradable like shares, investors have to pay various fees and taxes associated with trading. These include STT, brokerage charges, etc.
Types	Two examples of these funds include international Funds and gold funds.	ETFs may invest in multiple asset classes or assets across different sectors. A few types of ETFs include gold ETFs, currency ETFs, and bond ETFs.

Taxation of Exchange Traded Funds and Fund of Funds

Here, we will discuss the taxation of ETF and FOF.

Exchange-traded funds

There are two types of ETFs – equity ETFs and non-equity ETFs. Taxation of equity ETFs is much like equity mutual funds. The gains arising from the sale of ETF units are subject to STCG tax and LTCG tax, depending on the holding period. If the holding period is below 12 months, short-term capital gains are taxable at 15% plus applicable surcharges.

However, if the holding period crosses 12 months, the realized returns are termed LTCG and taxed at 10% without indexation benefit. One can get a tax exemption for LTCG of up to Rs. 1,00,000.

In the case of non-equity ETFs, taxation is similar to debt mutual funds. STCG is applicable on these funds when the holding period is less than 36 months. The gains are taxable as per the slab rates of investors. However, if the holding period crosses 36 months, LTCG is tax applicable on gains arising from these. The rate of taxation is 20% post indexation benefit.

Fund of Funds

FOFs are subject to taxation when investors redeem their units. STCG applies to gains arising from holdings having a tenure of fewer than 36 months. The rate is similar to debt mutual funds. In the case of FOFs holding more than 36 months, LTCG is applicable on gains arising from them. In such a case, you will have to pay taxes at the rate of 20% after taking into account the indexation benefit. FOFs are also subject to dividend distribution tax on dividend payouts.

Final Word

Both ETF and FOF have distinct characteristics. You need to consider various aspects such as risk appetite, investment goals, the experience of the fund manager, and expense ratio before investing your money.

Frequently Asked Questions

How can I invest in ETFs?

To invest in ETF, you must open a Demat account with a broker and complete the KYC formalities. After that, you can buy units of ETFs just like shares. You can also invest in Kuvera, which is a zero brokerage, zero-commission platform to invest in direct mutual funds. Click here to get started.

What are the benefits of investing in FOFs?

One of the most significant advantages of investing in FOF is diversification and risk reduction. The risk is spread out among hundreds of stocks or debt securities of different mutual funds. Another advantage is that these funds do not depend on the performance of one manager.

What happens to the dividend that an ETF earns from the underlying stocks?

Usually, an ETF’s dividends from the underlying securities are reinvested in that fund.

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