ETF vs FOF: What's the difference?

Diversification is an essential aspect of strategic investing. However, identifying suitable investment avenues to build a diversified portfolio can be a daunting task, especially given the wide range of financial instruments.
Among these, Exchange-Traded Funds (ETFs) and Funds of Funds (FOFs) stand out as popular choices for diversification. While both schemes aim to mitigate risk and optimise return potential, they differ significantly in their structures, management styles, costs, and taxation.
Understanding the nuances of ETF vs FOF is important for making informed investment decisions tailored to individual goals and risk appetites.
- Table of contents
- What are exchange-traded funds (ETFs)?
- Key features of ETFs
- Types of ETFs
- What are funds of funds (FOFs)?
- Key features of FOFs
- Types of FOFs
- Differences Between ETF and FOF
- Taxation of ETFs in 2024
- Taxation of FOFs
- Which one should you choose between ETF vs FOF?
What are exchange-traded funds (ETFs)?
An Exchange-Traded Fund (ETF) is a type of financial instrument that pools money from investors to invest in a diversified basket of securities like stocks, bonds, or commodities. ETFs are traded on stock exchanges, much like individual stocks, and their prices fluctuate throughout the trading day based on market demand and supply.
Key features of ETFs
- Passive management: Most ETFs track an index (e.g., Nifty 50 or BSE 500) and aim to replicate its performance. This passive management results in lower expense ratios.
- Liquidity: ETFs can be bought or sold at any time during market hours, providing high liquidity.
- Cost-effectiveness: Due to their passive nature, ETFs typically have lower management fees compared to actively managed funds.
Types of ETFs
- Equity ETFs: Invest in stocks that track an index.
- Bond ETFs: Provide exposure to fixed-income securities like government or corporate bonds.
- Commodity ETFs: Focus on commodities such as gold or silver.
- Sector/Thematic ETFs: Target specific industries or themes (e.g., technology or ESG).
- International ETFs: Offer exposure to foreign markets.
- Factor ETFs: Focus on specific factors or characteristics of stocks to construct their portfolios (such as value, growth, momentum etc).
What are funds of funds (FOFs)?
A Fund of Funds (FOF) is a mutual fund that invests in other mutual funds or ETFs rather than directly in stocks or bonds. This structure allows FOFs to create a diversified portfolio by pooling investments across multiple underlying funds, without having to manage the individual funds themselves. A Fund of Fund can invest in multiple schemes within the same mutual fund house/asset management company, as well as schemes of different companies.
Key features of FOFs
- Active management: Managed by professional fund managers who adjust the portfolio based on market conditions and investment goals.
- Diversification: By investing in multiple funds across asset classes, FOFs offer broad diversification. They allow investors to access multiple asset classes, schemes and even mutual fund houses through a single investment.
- Multiple risk profiles: FOFs cater to various risk appetites by selecting underlying funds that align with specific objectives.
- Higher costs: FOFs can have higher expense ratios as the investor pays a management fee for both the main fund as well as the underlying fund/s.
Types of FOFs
- Asset allocator/multi-asset FOFs: Invest across equities, debt, commodities, etc., for balanced diversification.
- International FOFs: Focus on global markets by investing in foreign mutual funds or ETFs.
- Gold FOFs: Invest in gold-focused funds or ETFs for exposure to gold prices.
- Multi-manager FOFs: Include multiple mutual funds managed by different fund houses.
- Sector-specific FOFs: Target specific industries like technology or healthcare.
Differences Between ETF and FOF
While both ETFs and FOFs aim for diversification, their structure and functioning differ significantly. Here’s a detailed comparison.
Parameter | ETF | FOF |
---|---|---|
Structure | Basket of stocks, bonds, or other securities tracking an index | Basket of diversified mutual funds |
Management style | Passively managed | Actively managed |
Price determination | Traded at market price throughout the day | NAV calculated at the end of the trading day |
Liquidity | High liquidity; can be traded anytime during market hours | Lower liquidity; redemptions may take a few business days. |
Costs/Expense ratio | Lower due to passive management | Higher due to dual-layered expenses |
Taxation of ETFs in 2024
The tax treatment of ETFs depends on the type of ETF (equity, debt, gold, or international) and the holding period.
1. Equity ETFs
- Short-term capital gains (STCG)
- Gains from equity ETFs held for less than 12 months are now taxed at 20%, up from the previous rate of 15%, effective July 23, 2024.
- Long-term capital gains (LTCG)
- Gains from equity ETFs held for more than 12 months are taxed at 12.5% without indexation benefits, replacing the earlier rate of 10%.
- An exemption limit of Rs. 1.25 lakh per financial year applies to LTCG, up from Rs. 1 lakh previously.
2. Debt ETFs
After April 01, 2023, capital gains from debt ETFs are classified as short-term, regardless of the holding period, and taxed at the applicable income tax slab rates.
Taxation of FOFs
Unlike regular mutual funds, FoFs are taxed as equity funds only if:
- At least 90% of the fund's corpus is invested in equity-oriented mutual funds
- These mutual funds in turn must have at least 90% exposure to equity shares of Indian companies listed on recognized stock exchanges.
In comparison, regular mutual funds are considered equity funds for taxation purposes if they allocate 65% of their portfolio or more to equity and equity-related instruments.
Equity oriented FOFs are taxed as follows:
- Short-term capital gains (STCG)
- Gains from equity oriented FOFs held for less than 12 months are taxed at a rate of 20%.
- Long-term capital gains (LTCG)
- Gains from equity oriented FOFs held for more than 12 months are taxed at a rate of 12.5% beyond the Rs. 1.25-lakh annual exemption limit.
For debt oriented FoFs, all gains are treated as short-term capital gains (STCG), regardless of the holding period, and taxed at the investor’s applicable tax slab.
Which one should you choose between ETF vs FOF?
The choice between an ETF or and an FOF depends on various factors such as investment goals, risk tolerance, costs, and liquidity needs.
1. An ETF may be suitable if:
- You prefer low-cost investments with high liquidity.
- You have access to a demat account and are comfortable trading on stock exchanges.
- Your goal is to passively track market indices.
2. Choose an FOF if:
- You seek professional fund management tailored to specific goals.
- You want exposure to multiple mutual funds without managing them individually.
- You are willing to bear higher costs for active management.
Conclusion
The choice between ETF vs fund of funds (FOF) comes down to your investment style and objectives. While ETFs offer cost-effectiveness, liquidity and trading flexibility, FOFs offer wider diversification and active management—albeit at higher costs. Understanding the difference between ETF and FOF helps investors align their choices with financial goals while optimising the return potential within acceptable risk levels.
FAQs:
What are the types of fund of funds (FOF)?
FOFs include asset allocator/multi-asset funds, international funds, gold funds, multi-manager funds, sector-specific funds, single-strategy funds, regional/geographic-specific funds etc.
What are the different types of exchange-traded funds (ETFs)?
ETFs include equity ETFs, bond ETFs, commodity ETFs (e.g., gold), sector/thematic ETFs, international ETFs, leveraged/inverse ETFs, factor-based ETFs etc.
Is it better to hold mutual funds or ETFs?
ETFs are technically a type of mutual fund. However, most mutual fund categories offer active management but come with higher costs compared to passively managed ETFs. The choice depends on your preference for active versus passive investing.
Which is better: ETF or Index fund?
Both investment avenues passively track market indices but differ in trading mechanisms. ETFs are traded on the stock exchange like regular stocks and offer intra-day liquidity, whereas index funds are priced at the end of the business day and can be redeemed at the closing Net Asset Value. Standard redemption timelines apply.
Is it okay to hold an ETF long term?
Many investors hold ETFs long term due to their low costs compared to actively managed mutual funds. However, the type of ETF can influence the holding period it is suitable for. Equity ETFs may be more suitable for long-term investments than debt ETFs.
Mutual Fund Investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.