ETF or Exchange Traded Fund is a passively managed fund which simply tries to replicate an 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 give you the same returns as the Sensex 30. An ETF will typically hold all the stocks in an index, in the same weights as they occupy in the index. An ETF is not actively managed by its fund manager and hence its expense ratio tends to be lower than a mutual fund. An ETF is actively traded on the stock exchanges and you can buy and sell ETF units on an exchange. You cannot easily do this in a mutual fund. Instead you buy and sell mutual fund units directly from the fund house concerned.
Features of ETFs
ETFs can invest in stocks, bonds or commodities: ETFs don’t necessarily just track stock indices. They can also track bond indices (such as liquid ETFs) or commodities (such as gold ETFs).
ETFs are actively traded on an Exchange: An ETF is 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 the NAV of the ETF. In case of a mutual fund, you buy and sell units from the fund house, at the NAV. You also need a demat and trading account to invest in an ETF. In theory you can buy and sell even an ETF directly with the fund house. However the size of such transactions is stipulated at high values and is out of reach of most ordinary investors.
Note that all ETFs do not have the same liquidity on the stock exchange. In general large ETFs with significant assets under management, will have more liquidity. You just generally prefer these types of ETFs over their smaller counterparts.
ETFs are passively managed: An ETF is necessarily a passive instrument. 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. Most mutual funds are actively managed. However there is a class of mutual funds called index funds which are also passively managed and have low expense ratios. Such mutual funds sometimes hold units of ETFs rather than the underlying stocks or commodities.
ETFs have lower expense ratios: ETFs are passively managed and hence have lower expenses than mutual funds. This can result in higher returns in ETFs over the long term.
5 year returns on major ETFs in India
|ETF||5 year returns (CAGR)|
|SBI Sensex ETF||11.74%|
|ICICI Pru Nifty ETF||11.71%|
|Reliance ETF Bank BeES||18.38%|
|Reliance ETF Gold BeES||0.64%|
Data as on 26/10/2018; Source: Value Research
Should you invest in ETFs or mutual funds?
The answer ultimately boils down to whether you believe that active management can beat indices in the long run. If you believe in active management, invest in mutual funds. If you believe in passive investing, invest in ETFs. People who believe in the Efficient Market Hypothesis (EMH), do not believe that active management can beat index investing. The EMH states that market are efficient in the long run and all winning fund management strategies are replicated and arbitraged away. Hence in the long run, passive low-cost investing will outperform.
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.