Why Fund of Funds (FOF) and ETFs have not taken off in India - Motilal Oswal
Why Fund of Funds (FOF) and ETFs have not taken off in India - Motilal Oswal

Why Fund of Funds (FOF) and ETFs have not taken off in India…

ETFs in India are much younger than mutual funds as an industry. These ETFs are hardly a little over a decade old but are yet to take off in a big way in India. ETFs are typically created on specific benchmarks or on specific assets. For example, you can have an ETF on Gold or an ETF on Silver or you can also have an ETF on any of the indices like the Nifty or the Bank Nifty. How does a Gold ETF operate? The ETF actually holds equivalent amount of gold with the custodian bank and issues gold ETFs against that. Therefore, your gold ETFs are perfectly secure as they are backed by physical gold with a custodian bank. Similarly, in case of index ETFs the ETF fund actually holds the component stocks in the same proportion as the index. Fund of Funds (FOF), on the other hand is a module wherein the FOF undertakes to create a portfolio of funds by mixing and matching funds to suit your specific requirements.
 
ETFs are different from normal mutual funds in one very important way in that they are listed and traded on a stock exchange. So Gold ETFs can actually be bought and sold on the NSE like any other stock by paying brokerage and STT. They are directly credited to your demat account like any other stock. There are market makers who actually make market for ETFs by giving buy and sell quotes before actual trading picks up in them. FOFs in India have predominantly been global funds. Indian mutual funds with global affiliations have used the FOF route to create a portfolio of global funds of their foreign stakeholder to enable Indian investors to indirectly get access to global markets. But with global markets not exactly generating too much of alpha, the focus on FOFs has been limited.
 
Why say no to ETFs in India – The returns perspective
ETFs account for less than 1% of the total AUM of Indian mutual funds. There are 3 key reasons for this. Firstly, Indians are familiar with discrete debt and equity products. They are not comfortable with a product like ETF which is more difficult to understand compared to a pure FD or a pure equity product. Lack of awareness is one reason that ETFs have failed to take off in a big way. Secondly, India is a market for alpha. Most investors are not impressed with the idea of investing in equity for the sake of earning benchmark returns. They find SIPs in diversified equity funds a better bet. Since the fund manager is able to use his discretion in an active fund, the performance is better through stock selection. On the other hand, the Nifty has virtually been flat between March 2015 and March 2017. While an Index ETF would have given negligible returns in this period, diversified equity funds have clearly outperformed. Lastly, ETFs are not very economical in cost terms unlike in the US and European markets. When you add up the fund administration cost of an ETF and then impute the market brokerage and STT and connected charges, there is not much of a cost benefit in ETFs.
 
Why say no to ETFs in India – The taxation perspective
Another important reason why ETFs in India have not taken off is the taxation perspective. In case of normal equities or equity mutual funds the tax treatment is entirely similar. If they are held for a period of less than 1 year then it is short term capital gains and if it is held for a period of more than 1 year it is classified as long term capital gains. In both these cases, long term capital gains are tax free and short term capital gains are taxed at the concessional rate of 15%. That is exactly where ETFs are at a disadvantage. Firstly, an ETF profit will qualify as long term capital gains only if it is held for a period of more than 3 years. Anything less than 3 years in case of ETFs is classified as short term capital gains. Secondly, the tax rate is also unfavourable. In case of ETFs in India, short term capital gains are taxed at the peak rate of tax for the investor concerned while long term capital gains are either taxed at 10% without indexation or at 20% with indexation benefits. ETFs in India, therefore, score lower in terms of returns as well as in terms of tax efficiency. Surely, a good case to say not to ETFs!
 
Then what about FOFs
Fund of Funds (FOFs) is a very popular concept in the West and even across Asian economies. Most institutions use the FOF approach to investing in mutual funds. In performance terms, these FOFs have failed to flatter. Anyways, an FOF focusing on global markets does not exactly add value when the whole world is looking to India for alpha. Secondly, FOFs also get unfavourable tax treatment. Even if an FOF aggregates equity funds, it is treated as a debt fund for tax purposes. That is a key reason why FOFs have not taken off in India.
 
ETFs in India have not yet taken off in a big way, nor have FOFs. Apart from the cost and the returns factor, the tax implications go a long way in investors preferring normal equity funds over ETFs.

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