ETF vs FOF: What Savvy Investors Must Know

If we look 10 years back, we only had a few investment tools or options we can say, but in today’s world, we have been introduced to many new and versatile investment options like Index Funds. These investment options not only give us confidence but also enhance our overall view towards the world of investment. 

Among these many investment options, we have two options, namely ETF or Exchange Traded Funds, and FOF or Fund of Funds. In this post, we will be talking about ETF vs FOF, their respective benefits, characteristics, taxation criterias and much more.

What is an ETF (Exchange Traded Fund)?

ETFs or Exchange Traded Funds are, in nature, similar to mutual funds. The underlying principle of their working is similar to how mutual funds are created, the only difference being that they are directly traded or listed on stock exchanges.

We can buy and sell them only through stock exchanges, and their prices vary just like the other stock prices.

What is FOF (Fund of Funds)?

FOF or Fund of Funds is simply a mutual fund that carries other mutual funds in its portfolio. Instead of how usual mutual funds have stocks in their portfolio. FOFs can have ETFs or other mutual funds in their portfolios.

How ETF work?

An ETF, if we put it in a simpler way, we can say that it’s a basket of stocks. Fund Managers collectively can put together some or many stocks and make a fund out of them. Basically, from the investor’s perspective, we can say that we are simply investing in a basket of stocks that have been put together by the fund manager.

Now these baskets of stocks or the stocks in the particular fund can be picked together totally by the fund manager, or there are several Indices already present in the stock market. These Indices are nothing but a collection of stocks, the only difference being that this collection of stocks is not created by the fund manager; instead, they are created by the stock exchange, which in turn are replicated by the fund managers in their fund portfolio.

Unlike mutual funds, ETFs are traded on stock exchanges just like regular stocks, and we can buy and sell them like we do with normal stocks. ETF prices vary just like share prices during the market hours. Liquidating ETF is as easy as liquidating regular stocks. ETFs can have both national or international stocks included in their portfolio.

The expense ratio of ETFs is generally very less ( generally less than 0.5%) and we can use our regular demat/shareholding/brokerage account in order to buy or sell them.

How does FOF work?

FOF or Fund of Funds is a mutual fund that has other mutual funds or ETFs inside its portfolio. We can not buy or sell FOF like a share; FOFs can be bought directly from the AMC (Asset Management Company) or several other third-party apps like Zerodha, Grow, etc.

FOF prices are indicated by the NAV (Net Asset Value). NAV is calculated using many factors like liabilities, respective fund asset values, and the number of total units of that particular mutual fund. Liquidating FOF is more tedious as compared to liquidating ETFs or regular stocks, as it takes more time for the units to get allocated in your folio (your mutual fund account), and also, while redeeming those units, it takes more time than ETFs.

FOF can have both national and international mutual funds in its portfolio. The expense ratio of FOFs is generally on the higher side as these funds are actively managed by the fund managers, and also, the AMC (Asset Management Company) charges are included here.

Taxation Criteria

Equity-Related ETF Taxation

If ETF is held for less than a year, then we incur STCG or Short Term Capital Gain, for which the value is set at 15%.

If they are held for more than a year, then we incur LTCG or Long Term Capital Gain. In case of LTCG if the value is within Rs 1 Lakh limit then the tax is being exempted but if its more than that then we incur 10% capital gain tax without indexation benefits (its a provision in the tax system through which investor can take account and adjust his/her capital gains with the current ongoing inflation, by using technique this the capital gains are reduced).

Gold and Other ETFs Taxation

If these kinds of ETFs are held for less than 3 years, then they are considered as short-term capital gains (STCG) , and the capital gains are directly added to your annual income and are taxed according to your tax slab rate.

If we hold these ETFs for more than 3 years, then long-term capital Gains (LTCG) are incurred at the rate of 20% per year. But here we can enjoy the benefits of indexation, unlike the equity-linked ETFs.

FOF Taxations

In case of Fund of Funds, no matter in which fund we invest in, whether it’s equity, debt, or gold-linked FOF, the following taxation criteria apply

If we hold the units for less than 3 years, then STCG is incurred, that is, the capital gains are directly added to your income and taxed accordingly to your slab rate.

If we hold the units for more than 3 years, then LTCG is applied at the rate of 20% and we can also have indexation benefits here as well.

Table of comparison (ETF vs FOF)

SPECIFICATION	ETF	FOF
Definition	ETFs are just like stocks; we can buy/sell them through the stock exchange, i.e, they trade on the stock markets. But unlike a stock, there isn’t a single company behind the ETF portfolio; instead, they hold a basket of stocks in their portfolio like a mutual fund	FOF is a type of mutual fund, a mutual fund that has other mutual funds or ETFs in its portfolio
Liquidity	Can be easily liquidated like regular stocks	Liquidity here is not as good as in ETFs; it takes some more time in mutual funds to liquidate your mutual fund units.
Taxation	Equity Related ETFs 1. STCG (less than 1 year)- 15% 2. LTCG (more than 1 year) :  If capital gains > 1 lakh – No tax If capital gains < 1 lakh – 10% (no indexation benefits) Gold/Other ETFs 1. Units held < 3 years (STCG) – Capital gains are added to your annual income and taxed accordingly 2. Units held > 3 years – 20% with indexation benefits	No master what kind of FOF you buy, the following taxation criteria apply: 1. Units held < 3 years (STCG) – Capital gains are added to your annual income and taxed accordingly 2. Units held > 3 years – 20% with indexation benefits
How to Invest	Can be bought/sold using your regular demat account	Can buy/sell either through any AMC or any other third-party apps.
Expense Ratio	Generally less (< 0.5%)	Usually higher than ETFs (includes AMC charges also)

Conclusion

In summary, we can say that both the investment options, ETF vs FOF, are diversified in their way. ETFs are a low-cost option, while FOFs have higher charges but come with more expert opinions. One should analyse their own investment goals, risk tolerance, and the time frame for which they can remain invested, and should decide accordingly while picking them up. This is how in this blog we analyzed the key differences of ETF vs FOF.

FAQ

Disclaimer

This content is for informational purposes only and does not constitute financial advice. Please consult a qualified professional before making a financial decision.