EXCHANGE TRADED FUNDS

SHOULD YOU INVEST IN EXCHANGE TRADED FUNDS (ETFS)?

While awareness about Exchange Traded Funds (ETFs) is quite low in India, these funds are gaining traction amongst investors over the last few years. In the last 5 years, the mutual fund industry assets under management (AUM) in ETFs have grown at a CAGR of more than 100%. In the developed markets, ETFs and index funds are hugely popular with investors. In this article we will discuss about ETFs and whether these funds can be suitable for their investment needs.

Exchange Traded Funds

Exchange traded funds are passive schemes, which aim to track a particular market index like Sensex, Nifty, Nifty Bank etc. ETFs invest in a basket of stocks which replicate the index. These funds do not aim to beat the index like actively managed mutual fund schemes; they aim to minimize the tracking error. Tracking error is difference in returns of the ETF and that of the index. When investing in ETF you should expect to get the index returns, if any, nothing more and nothing less.

Advantages of ETFs versus actively management MFs

  • Cost: The biggest advantage of ETFs over actively managed funds is cost. The expense ratio of ETFs can be upto 1.5 to 2.25% lower than actively managed funds. Actively managed funds need to beat their benchmark by that margin to match returns of comparable ETFs. Top performing actively managed mutual funds have historically delivered high alphas to investors, but many average and below average performers struggle to beat the benchmark. Over long investment tenors the cost advantage of ETFs versus actively managed funds, can be of significant advantage to investors.
  • 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 or study fund’s performance in up and down markets etc. Simply you may select an index and invest in a low cost ETF, which tracks that index.

Future of ETFs and index funds

A few years back, the legendary investor, Warren Buffett advised his own family to put his wealth in index funds after he is gone – such is his conviction that index funds will beat actively managed funds in the long term. His belief is not without basis – more than 90% of large cap companies in the US failed to beat the S&P 500 index over long investment tenor.

If you look at the last 1 year in the Indian Markets as well, ETF funds have beaten most equity mutual fund categories. This may simply be due to market conditions which favored large cap, but the interesting point here is that ETFs were able to beat large cap equity mutual funds. In the long term, the performance differential between actively managed funds and ETFs will narrow.

Conclusion

Exchange Traded Funds (ETFs) are excellent investment options for passive investors, who want to beat inflation and get returns over a long investment horizon. Actively managed funds will continue to form the major part of investment portfolios, but ETFs and index funds will gain an increasing share of wallet over time. Investors should educate themselves about ETFs and index funds, so that they can take informed investment decisions.

 

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