What are the benefits of investing in ETFs?

Exchange traded funds or ETFs are passive mutual fund schemes which track an equity or debt market index or price of a commodity (e.g. Gold). ETFs invest in a basket of stocks that reflects the composition of a market index e.g. Sensex, Nifty etc. The weight of a stock in the underlying portfolio of an ETF mirrors the weight of stock in the benchmark index. Unlike actively managed mutual fund schemes, ETFs do not aim to beat the index. The investment objective of ETFs is to track the index as closely as possible. ETFs are listed on stock exchanges and are traded like shares of companies. You need to have Demat and trading accounts to invest in ETFs. You can buy / sell ETF units in the stock exchange through your trading account, just like how you buy or sell shares of listed companies.

ETFs in India

ETFs have been growing in popularity all over the world, especially in developed markets. India is not behind in this trend. Since the outbreak of the COVID-19 pandemic, ETFs have taken off in a big way in India. June AMFI data shows that ETFs as a category (including Gold ETFs) is the largest mutual fund category with assets of Rs 5.6 lakh Crores (as on 30^th June 2023, source: AMFI). Today (as on 30^th June 2023), there are 172 ETFs out of which a large majority are Equity ETFs (124 equity ETFs). Debt ETFs, especially target maturity ETFs have also grown in popularity with more than 20 debt ETFs. In addition to equity and debt ETFs, there are 12 Gold ETFs. In addition to equity, debt and gold ETFs, we also have silver and international ETFs. A large number of ETFs have been launched in the last 3 – 4 years. We have created a dedicated ETF section in our website, Advisorkhoj.com. You will get all the information you need on ETFs in our ETF section.

Why you should invest in ETFs?

In the last 3 years, ETF AUM has multiplied by 3 times at a CAGR of 44% (as on 30^th June 2023, source: AMFI). Why are ETFs gaining popularity? There are several benefits of ETFs compared to actively managed fund schemes.

• There are two kinds of risk in equity investments – systematic risk or market risk and unsystematic risk. Systematic risk affects the entire market / asset class. Systematic risk is uncontrollable risk. It cannot be reduced through diversification. Unsystematic risk affects specific stocks. Unsystematic risk can be reduced through diversification.
  
  Actively managed mutual funds have both systematic and unsystematic risk. While active funds reduce unsystematic risk through diversification, they have unsystematic risks because they have to be overweight or underweight on some stocks versus the benchmark index in order to beat the index. While being overweight or underweight on certain stocks can help the fund manager create alphas, sometimes it can also result in underperformance against the benchmark index if the overweight stocks underperform.
  
  ETFs are not overweight or underweight on any stock. There is no unsystematic risk in ETFs. Stocks in the ETF’s underlying portfolio have exactly the same weight as they have in the index. ETFs are only subject to systematic or market risk.


• Fund managers of actively managed mutual fund schemes may have human biases and can make errors of judgment. There is no human bias in ETFs. An ETF will not have human bias towards any stock – the stock will have the same weight in the ETF as it has in the market index.


• Another benefit of ETF is that there is very little fund manager dependence. The over or underperformance of an actively managed mutual fund scheme is attributable to the fund manager. Change in fund manager can have an impact on the performance of the mutual fund investment. On the other hand, change in fund manager will have very little impact on ETF performance.


• Total Expense ratios (TER) of Exchange Traded funds are much lower than actively managed mutual fund schemes. Expense ratios and TERs have a direct impact because TERs are deducted from the market value of the underlying securities of the scheme portfolio to arrive the scheme’s Net Asset Values (NAVs). 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 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.


• Another advantage of ETFs is that outperformers get higher weights in market capitalization weighted indices i.e. if the market cap of a stock increases more than that of another one, the weight of the outperformer in the index will increase more relative to the other one. ETFs tracking market capitalization weighted indexes like Sensex or Nifty will reward the outperformers. Actively managed mutual funds in India may be restricted in terms of concentration risk mandates for particular stocks.

Conclusion

ETFs are extremely popular in developed economies. They are getting increasing popularity in India also. ETF is only of the fastest growing mutual fund categories in India over the past few years. Investors should consult with their financial advisors or mutual fund distributors if ETFs is suitable for their investment needs.