Should you invest in Exchange Traded Funds?

Exchange traded fund or ETF are passive mutual funds, which aim to track a particular market index like Sensex, Nifty, BSE – 100, Nifty – 100 etc. and replicate it returns. When investing in ETF you should expect to get the index returns, nothing more and nothing less.

Differences between ETFs and actively managed Mutual Fund schemes

  • In active mutual funds, investors do their transactions with the fund house. ETFs are listed on stock exchanges and can be bought or sold like stocks.
  • Mutual fund net asset values (NAVs) are priced at the end of the day. ETF prices, like stock prices, change real time throughout the day.
  • You can invest in mutual fund schemes through mutual fund distributors, Registrar and Transfer Agents or directly from the AMCs. In order to invest in ETFs you need to have a demat account with a stock broker.
  • ETFs do not aim to beat the benchmark index; they aim to track the benchmark index.
  • Being passive funds, ETF expense ratios are much lower than actively managed mutual funds.

Advantages of ETFs versus actively management MFs

  • Cost: The main advantage of ETFs over actively managed mutual funds is the cost known as total expense ratio (TER). TER of ETFs can be 2.25 to 2.5% lower than actively managed funds. Actively managed funds need to beat their benchmark by over 2% just to match returns of comparable ETFs. Over long tenors, the cost advantage of ETFs versus actively managed funds, can be of significant advantage to investors.
  • Unsystematic Risk: Equity investments are subject to systematic risk and Unsystematic risks. Both ETFs and actively managed mutual fund schemes are subject to market risks known as systematic risk. But actively managed funds also have unsystematic risk such as company specific or sector specific risk. Though mutual funds aim to reduce unsystematic risk by diversifying across stocks and sectors, they will have some residual unsystematic risks because actively managed funds will be over-weight on certain stocks and sectors versus the index. ETFs do not have any unsystematic risk because they simply track the index. If you want to totally avoid unsystematic risk and only take market risk, then ETF is a better investment option for you.
  • Simplicity: Investing in ETF is much simpler than investing in actively managed funds. You do not have to analyze past performance, understand the fund manager’s investment style e.g. growth, value, GARP, study fund’s performance in up and down markets etc. Simply select an index and invest in a low cost ETF, which tracks that index.

We discussed about Exchange Traded Funds (ETFs). ETFs are excellent investment options for passive investors willing to beat inflation and get good returns over a long investment horizon. Actively managed mutual funds in India will continue to form the major part of mutual fund investment portfolios, but ETFs will gain increasing share of wallet over time due to its simplicity. Investors should educate themselves about exchange traded funds and invest in ETF.