Investors seeking exposure to an index can consider ETF investing as an option. Exchange traded funds are one of the many types of mutual funds available today and gaining popularity among various kinds of investors. While you may be familiar with equity mutual funds, debt funds or balanced funds, ETFs are yet another class of mutual funds that function a bit differently. ETFs are mutual funds designed to mimic popular market indices like the Nifty 100, BSE 100, Sensex etc. These are passively managed funds that simply hold the stocks of the index they are supposed to mimic exactly in the same proportion as the index. Since the fund managers don’t take active calls in security selection by holding the same stocks as included in the index, these funds are passively managed.
Exchange traded funds are suitable for first-time investors who would like to test the waters and may not be comfortable with the higher risk associated with regular mutual funds.
There are several advantages of investing in an ETF. Firstly, being passively managed they make fewer transactions as compared to actively managed funds where the fund manager must constantly look for securities that can help him outperform the scheme’s benchmark. This leads to higher portfolio turnover resulting in higher tax incidence. Funds pay taxes like STT (Securities Transaction Tax) and capital gains tax while buying or selling securities within their portfolio. Thus, ETFs are more tax efficient and have lower costs arising out of fund management.
Secondly ETFs also usually have lower expense ratio compared to actively managed mutual funds which must employ highly skilled fund managers for generating active returns.
Thirdly ETFs offer more convenience and liquidity to investors since they are listed on exchanges and trade like stocks. Investors can transact in ETF funds any time during market hours at real-time prices unlike actively managed mutual funds where NAV is computed only once a day after the market closes.
ETFs offer better diversification since they carry all the securities listed in the index which are periodically rebalanced. But the reduced risk arising out of greater diversification in exchange-traded funds comes at the cost of possibly lower returns as compared to other mutual funds. Actively run mutual funds are more likely to earn a better return over the long-term than passively managed funds since the fund manager uses his expertise and takes active calls to buy better-performing stocks and sell underperforming stocks. But in the case of an ETF that mimics an index, all kinds of stocks are held including the underperformers.
ETF investors should consider funds with lower tracking error as a key performance indicator. Tracking error shows the deviation in return of a fund from its benchmark. Since these funds mimic their respective indices, tracking error should be close to zero. However, zero tracking error is impossible since it must buy or sell securities to align with the index whenever the index undergoes a rebalancing and hence must bear some transaction costs. However, indices have no such constraints. Investors keen on lower expense ratio and higher liquidity can consider including ETFs in their financial planning.