ETFs V/s Mutual Funds
You must have heard from people that the gold ETF was the best investment in 2008! Are you aware what a gold ETF is? Let us first know what basically an ETF is.
ETF is the abbreviation for exchange traded fund, a financial instrument that tries to imitate its benchmark index by investing in stocks in the same proportion as that of the benchmark index.
On other hand a mutual fund is a trust that pools the savings of a number of investors and invests the collected money.
You can say that an ETF is similar to an index mutual fund which also invests in stocks in the same proportion as that of the benchmark index. So Nifty BeES ETF by Benchmark Mutual Fund invests in the same stocks as that of its benchmark S&P CNX Nifty Index.
You may be wondering how are ETFs different from mutual funds, as both collect money from investors and invest in scrips or other assets like gold.
The factors in which these two differ from each other are
ETF is the abbreviation for exchange traded fund, a financial instrument that tries to imitate its benchmark index by investing in stocks in the same proportion as that of the benchmark index.
On other hand a mutual fund is a trust that pools the savings of a number of investors and invests the collected money.
You can say that an ETF is similar to an index mutual fund which also invests in stocks in the same proportion as that of the benchmark index. So Nifty BeES ETF by Benchmark Mutual Fund invests in the same stocks as that of its benchmark S&P CNX Nifty Index.
You may be wondering how are ETFs different from mutual funds, as both collect money from investors and invest in scrips or other assets like gold.
The factors in which these two differ from each other are
Low cost:
ETF have lower cost as they are generally passively managed and invest only in index based stocks. They don’t trade, buy or sell stocks frequently, and the proportion for investment in each scrip is normally fixed, based upon the weightage of that scrip in the index.
Thus, ETF requires low management expertise as research and marketing expenses are less.
Mutual Funds on the other hand are more dynamically managed and hence have a higher expense ratio. Fund houses spend a lot of money on research of scrips. They buy and have a tendency to churn the scrips more frequently.
Take this for example Nifty BeES has a cost structure of around 0.50% as compared to 1.25% of ICICI Prudential Index Fund. Apart from management costs, mutual funds also charge entry and exit load which take almost 2% out of your total investments; whereas in ETF, you have to pay only brokerage charge.
Thus, ETF requires low management expertise as research and marketing expenses are less.
Mutual Funds on the other hand are more dynamically managed and hence have a higher expense ratio. Fund houses spend a lot of money on research of scrips. They buy and have a tendency to churn the scrips more frequently.
Take this for example Nifty BeES has a cost structure of around 0.50% as compared to 1.25% of ICICI Prudential Index Fund. Apart from management costs, mutual funds also charge entry and exit load which take almost 2% out of your total investments; whereas in ETF, you have to pay only brokerage charge.
Liquidity:
ETFs can be sold or bought like stocks during market hours, unlike mutual funds which can be bought and sold only at the day’s end as per their calculated net asset value (NAV).
To understand the above, lets us assume, if you want to redeem your investment on a particular day for some monetary need and by sheer bad luck the market begins to fall. As ETFs are traded on the markets you can minimize your loss by immediately selling your ETF.
Had you wanted to redeem from a mutual fund you would have had to wait till the end of the trading session for the generation of NAV; by the time the market might have fallen substantially, leading you to suffer a higher loss.
ETFs can be sold or bought like stocks during market hours, unlike mutual funds which can be bought and sold only at the day’s end as per their calculated net asset value (NAV).
To understand the above, lets us assume, if you want to redeem your investment on a particular day for some monetary need and by sheer bad luck the market begins to fall. As ETFs are traded on the markets you can minimize your loss by immediately selling your ETF.
Had you wanted to redeem from a mutual fund you would have had to wait till the end of the trading session for the generation of NAV; by the time the market might have fallen substantially, leading you to suffer a higher loss.
Long-term investor protection:
the stock exchanges, thus Asset Management Company managing the ETF is not involved in the transaction. However, in case of mutual fund, units are purchased and sold by the Asset Management Company.
This may lead to investors suffering if there is a large exit of money from the scheme as was witnessed in many mutual fund schemes during the October-November 2008 period. During the period, long term investors had to suffer, due to large outflow of funds from schemes which led to many fund managers selling their best assets in fire sales.
Thus, ETF protects long-term investors` value as assets are not sold even when there is large selling seen in ETFs.
This may lead to investors suffering if there is a large exit of money from the scheme as was witnessed in many mutual fund schemes during the October-November 2008 period. During the period, long term investors had to suffer, due to large outflow of funds from schemes which led to many fund managers selling their best assets in fire sales.
Thus, ETF protects long-term investors` value as assets are not sold even when there is large selling seen in ETFs.
Low tracking error:
ETFs have very low tracking error, which is the difference between the returns by funds measured against its benchmark index. This is because, ETFs invests in stocks that constitute the benchmark index, in the same proportion as their weightage in the index. Also the gap between ETF`s NAV and market price is less because of arbitrage opportunities which traders take advantage of.
On the other hand, mutual funds are not so keen to invest in stocks in the same proportion of the benchmark index of the scheme, and mostly deviate from the returns posted by the index. Index funds have high tracking error as there is no arbitrage between the funds` NAV and market.
Thus, if you believe that index will gain, have limited funds to invest in stocks, and not comfortable with any particular scrip, then exchange traded fund will be the right investment option.
ETFs have very low tracking error, which is the difference between the returns by funds measured against its benchmark index. This is because, ETFs invests in stocks that constitute the benchmark index, in the same proportion as their weightage in the index. Also the gap between ETF`s NAV and market price is less because of arbitrage opportunities which traders take advantage of.
On the other hand, mutual funds are not so keen to invest in stocks in the same proportion of the benchmark index of the scheme, and mostly deviate from the returns posted by the index. Index funds have high tracking error as there is no arbitrage between the funds` NAV and market.
Thus, if you believe that index will gain, have limited funds to invest in stocks, and not comfortable with any particular scrip, then exchange traded fund will be the right investment option.
