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Investing can be intimidating, particularly with various options in place. Exchange-traded funds (ETFs) and funds of funds (FOFs) are two popular vehicles that often top discussions.
To make informed choices that correspond to your financial goals, understanding the variations between these two options is crucial.
This article seeks to provide a detailed look at ETFs and FOFs, their distinctions and which could be a superior investment for you.
Also read: Best hybrid funds: A guide to investing in mutual funds
What is an ETF fund?
The full form of ETF is exchange-traded funds. ETFs are baskets of securities or indices traded on stock exchanges like individual stocks. Unlike traditional open-end mutual funds, ETFs can be traded all day long, much like any other stock on the market.
Compared with index funds, ETFs have lower transaction costs and annual changes. ETFs are a safer product for risk-averse or first-time investors who require market-linked returns.
Here are a few of the advantages of ETFs:
- Diversification and low cost
- In-kind creation/redemption process
- Convenience for retail investors
- Arbitrage opportunities and liquidity
- Cost efficiency and reduced distribution charges
- Flexible and instant exposure
Exchange-traded funds example
Here are a few of the actively trading ETFs and a few essential information about them as of July 3, 2024:
| Underlying asset | LTP | Volume | Value (₹ crores) | NAV |
| Nifty Bank | 54.18 | 1,66,976 | 0.9 | 53.3 |
| Mirae Asset Nifty Bank ETF | 534.09 | 12,006 | 0.64 | 524.85 |
| Nifty Financial Services Index | 24.46 | 4,25,223 | 1.04 | 24.02 |
| Bajaj Finserv Nifty Bank ETF | 53.33 | 44,379 | 0.24 | 52.38 |
| Nifty Bank | 53.76 | 14,486 | 0.08 | 52.86 |
Source: NSE
Also read: Crack the code to steady gains with value funds
What is FOF in mutual funds?
Rather than putting money directly into stocks, bonds, or other securities, a fund of funds (FOF) is an investment approach where one holds a portfolio of different investment funds. FOF scheme primarily invests in the units of another mutual fund scheme. It may be called multi-manager investment.
Through this kind of scheme, the investor can diversify risk by investing across several different funds. The underlying investments for a FoF are the units of other mutual fund schemes either from the same mutual fund or other mutual fund houses.
According to experts, fund of funds is more suitable for small investors who want to enter different asset classes and those whose advisors do not have enough knowledge to recommend single managers.
Here are a few of the advantages of FOFs:
- Easy rebalancing
- Diversification
- Expertise in different fund managers
- Convenience for international and gold investments
Must read: Diversification: Why it is important for your portfolio
How is FoF taxed in India?
A FOF scheme, as per section 112A of the Income Tax Act, would be treated as an equity-oriented fund if:
- The total proceeds of such a fund are invested in the units of another equity-oriented fund to a minimum of 90%, and
- Such other equity-oriented funds also invest at least 90% of their total proceeds on equity shares of domestic companies listed on recognised stock exchanges.
This means that if the FoF invests in the units of any other equity-oriented fund and fulfils the above conditions, then it will be considered an equity-oriented fund.
However, if these conditions are not satisfied, then such will be referred to as something other than an equity-oriented fund and subject to similar tax treatment applied to non-equity-oriented funds.
ETF vs FOF – Key differences
The decision of which one is better between the ETF and FOF depends on multiple factors. Here are a few of them:
Returns
Investors are always searching for high returns. Nevertheless, one has to understand that returns and risk are inseparable. Investors who are looking for more returns should be ready to encounter high risks. Furthermore, riskier investments should compensate investors with higher returns.
Consequently, it is upon the investors to carry out comprehensive due diligence about the fund before deciding to invest in it in terms of portfolio, asset allocation and strategy application. In the case of ETFs or FOFs, ensure you understand what you are putting your money into.
Investor profile
One size never fits all in investing. This means that investors must know themselves well enough to choose the investments that fit them best. The three main components of an investment profile include investor goals, risk tolerance level and investment horizon.
An investor has to make sure their investments match these three pillars at all costs, and only then will they be able to earn maximum profits from such an investment. Therefore, while selecting either ETF or FOF, they should consider these three pillars of the investor’s profile.
Diversification
Diversification, according to experts, helps reduce the risk in a portfolio. Hence, investors must spread investments across various asset classes. Unlike ETFs that invest in one mutual fund, FOFs are more diversified because they invest in many mutual funds at once.
Besides, they provide professional management because FOFs tend to have several fund managers who manage their portfolios concurrently. If someone needs diversification, then FOFs can be suitable for them.
Bottomline
Investors need to take into account their financial goals, risk tolerance and investment horizon before deciding whether to invest in ETFs or FOFs. For example, while ETFs may offer higher returns on lower costs, FOFs provide broader diversification and are managed by professionals.
Ultimately, a choice between investing in ETF or FOF should be dependent on the investor’s profile as well as his/her investment strategy meant to maximise income and meet one’s financial objectives.
FAQs
Investing in an ETF or a mutual fund depends on your financial goals and preferences. For those who are cost-conscious or actively buying/selling, ETFs are preferable because they have lower expenses, are more tax-efficient, and permit intraday trading. But if you prefer long-term investing with regular contributions, you would choose mutual funds that have professional management, possibly higher returns from active management and a minimum contribution approach.
There may be times when you might prefer mutual funds instead of ETFs. This is because professional management can lead to higher returns through active management. They also offer systematic investment plans (SIP) that make savings easy. Moreover, many mutual funds do not charge any transaction fee to the buyer or seller; thus, they are cheap in the long run for those investors who prefer taking a non-interventionist approach to investments.
In comparison to ETFs, which are traded on exchanges and consequently are affected by intraday market volatility leading to price changes, mutual funds are generally considered less risky. Additionally, there might be tracking errors arise between ETFs and their underlying indexes. However, professionally managed mutual funds exhibit stability in prices calculated at the close of each business day, giving them less exposure to daily market swings, hence reducing short-term risks.
An ETF may become zero, but it is not common. This is the case when the assets backing up the ETFS go bankrupt, for example, during extreme market crashes and company insolvencies in its portfolio. Besides, if an exchange-traded fund fails to attract enough investor interest, it could be liquidated, but shareholders usually receive NAV as of the date of dissolution.
Yes, you may sell them during the trading hours whenever you want. They are traded on stock exchanges like individual stocks, thus enabling intra-day trading. Consequently, throughout the day, traders can buy/sell shares by whichever EFT offers flexibility and liquidity, plus allowing day traders to profit from intraday price movements. Remember, however, that bid-ask spreads, as well as selling prices that might be affected by various market conditions, should be taken into account.