Are ETFs the right investment options for you?
Unlike in many developed economies, ETF or exchange Traded Funds (ETFs) are still not as popular as mutual funds in India among the retail mutual fund investors. The popularity of mutual funds compared to ETF can be attributed to structural difference of our equity market vis-a-vis the developed markets, but also due to lack of awareness about ETF schemes compared to mutual fund schemes.
Basic Characteristics of ETFs
- ETFs invests in basket of securities that, reflects the composition of a market index, like Nifty, Sensex, Bank Nifty, CNX – Midcap, Nifty – CPSE etc. Like mutual funds ETFs are also managed by Asset Management Companies.
- ETFs combine the characteristics of both, shares and mutual funds. Investors can buy or sell ETF units like the units of mutual fund schemes. However, ETFs can be bought or sold only in stock market.
- To invest in ETF, investors need to have demat and trading account.
- The price of an ETF unit is expressed in terms of Net Asset Value juts like mutual funds. However, the price of an ETF unit changes just like shares on a real time basis during market hours.
- ETFs aim to replicate an index, therefore, the fund manager aims to track the index as closely as possible and replicate it returns.
Difference between ETFs and Mutual Funds
- Investors do not need a demat account to invest in mutual funds, but need a demat account to invest in ETFs.
- The price of ETF changes real time throughout the day unlike a mutual fund, where NAV is calculated at the end of the day.
- ETFs are passively managed but mutual funds are actively managed. A Mutual fund manager tries to generate alpha over the benchmark it is following whereas ETFs aim to replicate return of a particular index.
- While ETFs only aim to track the relevant index returns and reduce tracking errors, mutual fund schemes have specific investment objectives like capital growth and income generation etc.
- You can invest in mutual funds in India through SIP, but you cannot start a SIP in ETF.
- Even though some mutual funds may be listed on the exchange, the liquidity on the exchange is quite low. ETFs on the other hand, are more liquid in the market since institutional investors mostly participate in ETFs.
- The cost of ETF is much lower than that of mutual funds, since ETF is passively managed. Mutual funds have higher expense ratio as the schemes are actively managed. Therefore, ETFs work out to be cheaper compared to mutual fund investment.
Should you invest in ETFs?
Research in the US has shown that, diversified equity mutual fund schemes have generally struggled to beat the S&P 500 (the broad based market index in the US) over a very long investment horizon. According to Warren Buffett, if fund managers are not able to beat the market, why should the investor pay more for actively managed mutual funds when ETFs are cheaper and better investment option?