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Why ETFs Work Better than Mutual Funds

Passive investing has picked up massively all across the globe over the last decade. In a lot of countries, funds invested in passive instruments exceeded actively managed assets under management. Several reasons have resulted in this movement towards just tracking the index, rather than trying to beat it. A few of them being:

  1. Active fund managers have been unable to beat indices consistently

  2. Fees for passive management are far lesser compared to active management, which truly brings out the effect of compounding

  3. Passive investing seems pretty stress-free relative to stock picking or relying on fund managers

  4. The number of products in the passive investing space have ballooned over the last few years, giving investors a wide choice for portfolio construction

Passive management in the Indian context

In India too, AUM under passive funds has been growing materially faster than actively managed funds, also thanks to the small base. However, India has been far behind in terms of product innovation, depth of markets and investor preference yet.

That said, multiple fintech players have ambitions of driving this space higher by constructing new products and that are extremely low on fees. Funds simply tracking a broader market can be managed in a very cost effective manner, especially with the help of technology.

What are the options available?

There are two ways of going about this:

Index Funds You probably already know this but, a mutual fund pools in money from many investors and invests the money in securities such as stocks, bonds, and short-term debt. Units of mutual funds can be purchased by investors.

An index fund is a type of mutual fund that invests in stocks that are similar to those in a specific market index. This implies that the scheme aims to match the benchmark index it is tracking.

A Nifty 50 index fund would essentially buy the 50 shares in the Nifty index in the same weightage as the index. As the prices of these stocks move, so will the weightage. The fund will keep adjusting these weight, ensuring it is perfectly in sync with the index.

Essentially, all it will do is mimic the index and give returns that are as close to the index as possible. There can be some errors because of buying and selling of securities; however, this is usually minute.

Exchange Traded Funds An exchange-traded fund (ETF) is a pooled investment security that functions similarly to an index fund. Except, it can be actively traded on the exchanges.

When you buy or sell mutual funds, it would typically take a couple of days to buy and sell the units. You would be essentially subscribing to or redeeming your units with the asset management company directly.

However, it works differently in the case of ETFs. You buy and sell your units from other investors over an exchange. So you don’t have to keep subscribing to or redeeming from the AMC.

Essentially, you can buy or sell at any time during market hours, and not wait a couple of days for your transactions to go through.

Which one is better?

There are some key differences between index funds and ETFs which can make a difference in terms of where to invest, despite both of them essentially just tracking the underlying index.

  1. Price - Mutual funds can only be settled at the end of the day for the closing price. ETFs, on the other hand, can be bought and sold at varying prices throughout the day. The transactions are also carried out in real time. In ETFs you will get the price right now, and not of later. Winner - ETFs.

  2. Derivatives - With mutual funds, you buy units and hold on to them. With ETFs, because they trade like stocks, you can also buy and sell derivatives on the instruments. This allows you to take leveraged positions, and even short sell. Winner - ETFs.

  3. Cost - When investing in mutual funds, there are two costs you could incur. Management fees that the mutual fund charges for doing all this work for you, and commissions that your distributor gets in case you are not on direct plans. With ETFs, you would incur management fees and brokerage (because you have trade them on a broking platform). While the management fee is almost equal for both, the other costs can vary depending on how you’re going about your investment. In any case, these are far cheaper than actively managed funds. Winner - Both!

  4. Liquidity risk - Because ETFs are traded on an exchange, there can be differences in the price of an ETF and the funds underlying NAV. This can make an index ETF trade at a premium or a discount to the underlying price. This typically happens when there are not many players actively involved in buying and selling on the exchanges. Given that the market in India for ETFs is relatively nascent, liquidity risk is pretty high for some ETFs. However, you can mitigate this risk by putting in limit orders rather than market orders. Winner - Index Funds.

  5. Dematerialisation - A lot of mutual funds, if brought through platforms don't really reflect in your demat account, like your shares do. However, with ETFs, they sit right there will all your other dematerialised shares. Winner - ETFs.

The final verdict

Overall, considering all the factors that we've listed out above, we have a clear winner - and that’s ETFs.

On that note, do check out the diversified portfolio we construct out of ETFs. These are all-weather portfolios which take exposure in large caps, mid caps, government bonds, corporate bonds and gold.

They are available in 3 options to suit the investors’ risk profile - aggressive, balanced and conservative. We simply play around with the allocation between risky and safe assets in these portfolios.

The advantage is that despite investing in different indices, these portfolios generate superior returns because of lower risk (diversification) and optimum allocation. Overall, across these portfolios we’ve been able to generate a CAGR of 12-17% over the last 10 years, which is higher than equity markets, for much lower risk!

Psst. All of this for a minimal annual management fee of 0.5%.

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