Since both ETFs and mutual funds basically invest pooled investment in various securities such as equity, debt or commodities, there is always an element of confusion for an investor while selecting one of the investment options. The article presents a comparative analysis of mutual funds and ETFs to help investors pick the right fit for him.
What is an ETF?
ETF or Exchange Traded Fund is a passively managed fund which simply tries to replicate an Index in terms of its investments as well as return performance. An equity ETF would pool in money from investors and invests in equities of various companies. The aim of the ETF is to generate similar returns as of the index.
For example, a Nifty ETF will try to give you the same returns as the Nifty 50 and a Sensex ETF will try to generate the same returns as the Sensex 30. The strategy is to typically hold all the stocks of the underlying index in the same weights as they occupy in the index.
However, ETFs don’t necessarily just track stock indices. They can also track bond indices (such as liquid ETFs) or commodities (such as gold ETFs).
Also Read: All You Need To Know About ETFs
Features of ETFs
Actively Traded: Unlike mutual funds, ETFs are actively traded on a stock exchange. A mutual fund may be listed on an exchange, but is typically not actively traded. Hence an ETF price can differ from the underlying value of the ETF (called NAV). It can trade at a premium or discount to the NAV of the ETF. You also need a demat and trading account to invest in an ETF.
High Liquidity: Since ETFs are tradable securities, they are highly liquid. However, not all ETFs have the same liquidity on the stock exchange. In general large ETFs with significant assets under management, will have more liquidity. Therefore, It is better to invest in large ETFs over their smaller counterparts as they have higher liquidity.
Passively Managed: An ETF is necessarily a passive instrument which makes them free from fund manager’s error problem which is very much a possibility in mutual funds. Some ETFs can track customised indices such as the Nifty Low Vol Index or the Sensex Next 50 Index (called Smart Beta strategies). However, they are still passive instruments.
Lower Expense Ratios: ETFs are passively managed and hence have lower expenses than mutual funds. Exchange traded funds in India have expense ratio as low as 0.10%! Cost efficiency results in higher net returns over the long term.
Top 5 ETFs in India
|Fund||Asset Class||1-Year Return||3-Year Return|
|Reliance ETF Long Term Gilt||Debt: Gilt||14.63%||–|
|UTI Sensex ETF||Equity: Large Cap||10.88%||15.40%|
|Motilal Oswal Nasdaq 100 ETF||Equity: International||9.13%||20.65%|
|Kotak Pru NV 20 ETF||Equity: Large Cap||13.50%||16.80%|
|Canara Robeco Gold ETF||Commodity: Gold||10.95%||2.99%|
*Data as on June 25, 2019
What are Mutual Funds?
Like ETFs, Mutual funds are also a type of investment option that pools investors’ money and invest in various securities on their behalf. However, unlike ETFs, they are not traded on listed exchanges.
Further, mutual funds are actively managed by professional fund managers to generate returns for its investors. In return, mutual fund houses charge investors with fund management fee in the form of expense ratio.
Also Read: Types of Mutual Funds
Benefits of Investing in Mutual Funds
- Diversification: Since mutual funds hold securities of multiple companies belonging to diverse sectors, they are always less risky than investing in direct equity. On average, a mutual fund holds shares of 30-60 companies in its portfolio because balances the risk.
- Transparency: The mutual fund industry is regulated by the Security and Exchange Board of India (SEBI) and very much transparent in terms of its investment decisions and holdings. This helps investors to keep track of their mutual fund investment.
- Investment Expertise: Investment in the stock market requires a lot of experience and expertise which requires lot of research and time. Since mutual funds are managed by experienced fund managers, they come with an advantage of professional fund management.
- Liquidity: Mutual funds can be redeemed by the unitholder as per his want which makes it a liquid investment option. However, unlike ETFs, mutual funds are not traded on bourses. Mutual fund transactions are executed only once a day after the fund house releases that day’s NAV.
Should you Invest in ETFs or Mutual Funds?
While comparing ETFs to mutual fund, you are essentially exploring the possibility that whether active management can beat indices in the long run. If you were to believe efficient market hypothesis, actively managed funds can not beat returns from index investing or exchange traded funds.
ETFs have been extremely popular in developed countries where it has consistently outperformed mutual funds. However, in the case of emerging market economies due to high growth potential, mutual funds have performed better than ETFs.
The biggest disadvantage with ETFs in developing countries is good companies in small and mid cap space with high growth potential are left out. However, in terms of risk, ETFs can be a better option as it invest in best of the companies of its space.
Therefore, if you are looking out for some kind of low risk-high returns type of combination, ETFs can be a great investment option for you.
However, if you are an individual willing to take moderate risk for earning higher returns and have long term investment horizon, mutual funds can be a great product for you.
Aside from this theoretical position, note that there is also one practical point to consider. You need a demat and trading account to invest in ETFs in India. If you are not comfortable with opening and maintaining these accounts, ETFs may not be appropriate for you. You can also invest in passive indices through index funds, rather than ETFs if you do not want to open demat and trading accounts.