Benefits of Investing in Exchange Traded Funds Explained
The assets of exchange traded fund is increasing globally at a fast pace. While a large part of the exchange traded funds global AUM is from the developed markets, the popularity of ETFs is growing rapidly in India as well. In the last 3 years assets under management (AUM) in ETFs in India grew at a compounded annual growth rate of (CAGR) 45% (source: AMFI). With AUM of over Rs 4.5 crores ETF is the largest category of mutual funds in India (source: AMFI). Around 30 new ETF mutual fund schemes were launched in India in the last 12 months (as on 19th August 2022). We now have ETF mutual fund across several asset classes e.g. equity, debt, gold, silver etc. We also have ETFs for multiple market cap segments and industry sectors.
What is ETF?
Exchange traded funds (ETFs) are passive mutual fund investments that track benchmark market indices (e.g. Nifty, Bank Nifty etc) or prices of commodities (e.g. Gold, Silver). ETFs invest in a basket of securities that replicate the benchmark market index ETFs and do not aim to beat the returns of the aimed benchmarks that they are tracking; they simply aim to give market returns subject to tracking errors. ETFs are listed on stock exchanges and are traded like stocks. You need to have demat and trading accounts to invest in ETFs
Benefits of investing in ETFs
- Costs or Total Expense ratios (TER) of Exchange Traded funds are much lower compared to actively managed mutual fund schemes. TERs have a direct bearing on return because TERs get adjusted in scheme NAV. In order to match or outperform ETF returns, an actively managed fund with same benchmark index as the ETF will have to beat by a margin that in percentage terms is as much as the difference in TER of the active fund and ETF. For example, if the TER of an ETF is 0.1% and that of an active mutual fund with the same benchmark mark index is 2%, then the active fund will have to beat the benchmark by 1.9% in order to match the performance of the ETF.
- Actively managed mutual fund schemes have to be overweight / underweight on certain stocks or sectors relative to the benchmark index since they aim to beat the benchmark index. This gives rise of unsystematic risk in the scheme. Unsystematic risk is the incremental risk over and above market risk, which all mutual funds are subject to. ETFs are only subject to market risk. There is no unsystematic risk in ETFs because they invest in a basket of securities that replicate the market index.
- Unlike actively managed mutual fund investments there is no fund manager bias in ETFs. Different active funds may outperform or underperform at different points of time because of this bias. Since there is no fund manager bias in ETFs, they are much simpler to select. An ETF with lower TER and tracking errors will outperform other ETFs tracking the same benchmark index.
Retail investments in ETFs took off in a big way during the COVID-19 pandemic. In this article, we discussed what ETF is and the benefits of investing in ETFs. Investors should consult with their financial advisors if ETFs are suitable for their investment needs.
