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© Venkatasubramanian K Explained: Why fund of funds are better than ETFs for passive investing

The low liquidity in ETFs (exchange traded funds) means that often the price quoted is at wide variance to the NAV (net asset value) of the scheme. Can fund of funds (FOF) help get over this shortcoming?

Demat account not needed

To transact in ETFs, you need broking and demat accounts. All those without a broking or demat account can opt for the fund of fund route.

Fund of funds purchase the units of the feeder ETF. For example, Mirae Asset ESG Sector Leader Fund of Fund purchases units of Mirae Asset ESG Sector Leaders ETF.

You can invest a lump-sum or take the systematic investment plan (SIP) route for an FOF. You can transact online or offline. It’s like dealing with any regular mutual fund.

Systematic investment plans

“Doing away with the need for demat account and allowing convenient tools such as systematic investment plans make FOF work for some investors,” says Anup Bhaiya, Managing Director, Money Honey Financial Services.

A few brokers allow ‘equity- SIP,’ which can be used in the case of ETF purchase. But there is no assurance that the intended number of units at the required NAV can be bought.

FoF lets you enroll for SIPs as well as systematic transfer plans.

Customization

FoF lets you invest as per your convenience for the amount you have. But when you deal with ETFs, you have to buy a certain number of ETF units. It all depends on the NAV of that day. For example, the NAV of Motilal Oswal MOSt Shares Nasdaq – 100 ETF quotes at around Rs 970. If you want to buy units worth Rs 10,000, then you have to purchase 11 units, a bit more than the intended sum. In India, fractions are not traded.

Many fund houses have already opted for splits of their ETF units to bring down the price per unit to make them more reasonably available.

Liquidity

If the units of ETFs are not traded with adequate volumes, then there is a fair chance that you may not get to transact close to the NAV at that moment of time. In case of FOF, the fund house undertakes the responsibility of executing the trade.

Though FOF may score on the assured liquidity front, there is a downside. ETF investors can take advantage of intraday volatility. A FOF, however, will allot units at the end-of-day NAV. If you look to benefit from a flash fall of, say, 5 percent on the underlying index, then the ETF is the way to go provided the price is almost equal to the NAV.

Also read: Index fund or ETF? Which works better?

Cost

A FOF charges expenses. The expenses are subject to change and are recurring in nature. For regular plans, expense ratio can range between 9 paisa for Rs 1000 and 68 paisa for Rs 100 invested.

ETFs entail paying brokerage – traditional brokers may charge 5-25 basis points while buying and selling the units. Discount brokers may charge a fixed Rs 20 per order or nil if you are buying for delivery. Though there are costs associated with the demat account, they are fixed in nature.

“You should compare the expense ratio of a FOF and the transaction costs associated an ETF and pick the one that is cheaper,” says Rupesh Bhansali, Head- Mutual Funds, GEPL Capital.

Also read: How direct plans of index funds score over ETFs on costs

For direct fund investors, FOF can further bring down the costs. But do not pick one just because the costs are low.

Gautam Kalia, Head-Investment Solutions, Sharekhan by BNP Paribas, says, “All the convenience that FOF offers to investors must be seen in the context of the costs it comes with. If the costs are on the higher side, then the net return available to investors gets reduced.”

“You should buy an ETF on the exchange or through an FOF if it serves your investment needs in a cost efficient manner,” says Bhaiya.