By: Tavaga Research
The Indian investment landscape has had significant changes in the last three decades. Investors have a variety of investment options to choose from, depending on their liquidity and risk appetites.
However, no investment strategy is perfect. Each investment strategy has its own set of benefits as well as drawbacks. Investors must be aware of the advantages and disadvantages of the various options available to make wise and informed decisions.
We’ll talk about two popular investment options, Exchange Traded Funds (ETFs) and Fund of Funds (FoF’s).
What is Fund Of Fund (FoF)?
FoF Meaning
A mutual fund scheme that invests in other mutual fund schemes / ETFs is known as a Fund of Fund. Instead of investing directly in equities or bonds, the fund manager manages a portfolio of other mutual funds.
An FoF may invest in a scheme run by the same fund house or in a scheme run by a different fund house. The portfolio is tailored to investors with a variety of risk profiles and financial objectives. As a result of investing in a variety of fund categories, investors can benefit from diversification.
The FOF can be both domestic and international. The fund manager of a foreign FoF invests in units of offshore mutual fund schemes.
What is Exchange Traded Fund (ETF)?
ETFs are passive funds similar to mutual funds in many ways except that they can be bought and sold on a stock exchange. The underlying investment funds are typically passively invested in stocks, mirroring the index composition. As the ETF product offering has grown in popularity since the early 2000s, bond and commodity ETFs are now becoming available.
ETFs are typically purchased to obtain market benchmark returns. It’s an excellent investment, particularly in India, where market returns (Nifty 50) have averaged around 13% p.a. over the last 15 years.
In India, ETFs are structured as a type of Open-Ended Mutual Fund scheme. ETF units can be traded on a stock exchange at any time during trading hours, and after settlement, they are held in your Demat account.
FoF vs ETF/ Fund of Fund vs Exchange Traded Funds
- Differences based on Structure
ETFs, like mutual funds, are a portfolio of securities. While the majority of them follow an index, they invest in stocks, bonds, and other securities.
FOF is a collection of mutual funds. They invest in other mutual funds based on risk tolerance and investment objectives.
- Differences based on Liquidity
ETFs, like stocks, can be traded on a stock exchange at any time of day. As a result, it is more liquid than mutual funds.
Liquidity is much lower for FoFs because they cannot be traded like ETFs. It takes a longer time to get the redemption amount into the bank account.
- Differences based on Selling Price
ETFs are bought and sold at market price, not Net Asset Value (NAV) because they are traded on a stock exchange. But all mutual fund schemes are purchased or sold at their NAV, this is a significant difference between ETFs and Mutual funds. The demand and supply for an ETF determine its market price.
The NAV calculated at the end of the trading day is used to trade FoFs.
- Differences based on Costs
ETFs are significantly less expensive than FoFs. Because most ETFs are passively managed and track an index, their expense ratio is typically less than 0.5 percent.
FoFs, on the other hand, are funds that are actively managed. As a result, the expense ratio is increased by the fund management cost. Furthermore, the mutual funds in which the FOF invests may levy fees that are passed on to the investor.
- Differences based on Taxation
Equity ETFs Taxation:
They are subject to a 15% tax on short-term capital gains (STCG) when ETF investments are held for less than one year.
They are subject to 10% tax on long-term capital gains (LTCG) when ETF investments are held for more than a year. LTCG on ETFs up to Rs. 1 Lakh are exempt. LTCG beyond Rs. 1 Lakh is subject to tax liability at the rate of 10% without indexation benefits.
Gold and other ETFs Taxation:
When ETF investments are held for less than three years, the short-term tax liability is incurred. Short-term capital gains are included in annual income and are taxed at the applicable income tax slab rate.
When ETF investments are held for more than three years, the long-term tax liability is incurred. Long-term capital gains are taxed at a rate of 20% per year, with indexation benefits.
FoF’s Taxation:
Regardless of the schemes we invest in, funds of funds are taxed similarly to debt funds. Even if we make the investment in equity funds, capital gains are treated as received from debt funds.
When ETF investments are held for less than three years, the short-term tax liability is incurred. Short-term capital gains are included in annual income and are taxed at the applicable income tax slab rate.
When ETF investments are held for more than three years, the long-term tax liability is incurred. Long-term capital gains are taxed at a rate of 20% per year, with indexation.
Examples of ETFs in India
- CPSE ETF
The CPSE ETF is an open-ended index exchange-traded fund. The CPSE ETF simply replicates the Nifty CPSE index which is made up of public sector companies of India. The CPSE ETF is managed by Nippon India.
- Bharat 22 ETF
As the name goes, the Bharat 22 ETF managed by the ICICI Prudential AMC simply replicates the Nifty Bharat 22 Index. The index is made up of 22 stocks that are Strategic Holding of Specified Undertaking of Unit Trust of India (“SUUTI”) and include Central Public Sector Enterprises (“CPSE”), Public Sector Banks, and private entities. These 22 stocks are spread across six industries (Basic Materials, Energy, Finance, FMCG, Industrials, and Utilities).
- SBI Gold ETF
SBI Gold ETF replicates the spot price of physical gold in India.
- Motilal Oswal Nasdaq 100 ETF
It is an open-ended scheme that tracks the Nasdaq 100 Index which invests in the largest 100 US stocks.
Examples of FoF’s in India
- SBI International Access – US Equity FoF
It is an open-ended fund of funds scheme that invests in units of one or more mutual fund schemes / ETFs, which are domiciled overseas and predominantly invest in US markets.
- Kotak Nasdaq 100 FoF
An open-ended fund of funds investing in units of overseas ETFs and/or Index Fund based on NASDAQ-100 Index.
- Motilal Oswal Nasdaq 100 FoF
An open-ended domestic fund of fund scheme investing in Motilal Oswal Nasdaq 100 ETF.
- Nippon India Passive Flexicap FoF
The open-ended fund of funds investing in units of ETFs/Index Funds of Nippon India Mutual Fund.
What should an investor choose?
Investment Strategy
We need to make investment decisions based on our investment profile. Risk tolerance, financial goals, and the timeline of the goal are the three pillars of an investor profile. Our portfolio will work well for us as long as our investments are in line with these three aspects.
We can take advantage of the widely diversified portfolio of FoF’s underlying funds if we want more diversification. ETFs, on the other hand, maybe a better choice if we want to profit from the growth of an index or a basket of securities.
For instance, if an investor with a high-risk tolerance invests in an ETF that tracks the Sensex of Nifty, the results will fall short of his expectations. If an investor with low-risk tolerance invests in FoF might get carried away with market moments and panic about buying and selling.
Style of Investment
If we want to build a portfolio with a passive investment style, ETFs might be the way to go. FoF’s, on the other hand, are a good option for active investors who want to benefit from the performance of other mutual funds.
Reliance on the Fund Manager
ETFs are index or benchmark funds that are not actively managed. Their performance is largely determined by the index or benchmark they track. The performance of the FoF, as well as the underlying funds, is determined by the fund manager’s performance.
Diversification
FoFs provide a unique way to diversify our portfolio by investing in other mutual funds. As a result, we can benefit from multiple fund managers’ experience and expertise. Asset allocation funds, gold funds, international funds, ETF FoFs, and many more are available.
While ETFs can be traded on the stock exchange, they stick to stocks listed in the BSE or NIFTY Index. They provide better long-term returns.
How to Invest
To invest in ETFs, we will need a Demat account with our preferred broker. After we have set up our Demat account, we need to fund it, and then ETFs can be traded just like stocks on a stock exchange.
However, a Demat account is not necessary for buying mutual funds.
Ending Note
Exchange-Traded Funds are passively managed funds, whereas Funds of Funds are managed by seasoned professionals. As we’ve seen, both of these investment options are distinct and expose investors to different levels of risk.
So, before deciding which to invest in, we should consider our investment goal and whether it aligns with the ETF or FoF, and then make an informed decision.
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