Whether ETF is a good investment option

It is important that you understand the differences between ETFs and mutual funds, as they are different in many respects, while similar in some.

1. ETFs invest in a basket of stocks to replicate an index, e.g. Nifty, Sensex, BSE 100, BSE 200, CNX 500 etc. ETFs are traded on stock exchanges. Mutual funds on the other hand comprise of a basket stocks, with the objective of outperforming versus its benchmark index.


2. Unlike a mutual fund, where NAV is calculated at the end of the day, the price of the ETF changes real time throughout the day, based on the actual share prices of the underlying stocks at any point of time during the day


3. You need to have a demat account to invest in an ETF. On the other hand, you do not necessarily need a demat account to invest in a mutual fund.


4. Fees charged by ETFs is lower than that of Mutual Funds. ETF expense ratios are around 0.5%, while mutual fund expense ratios are on an average around 2 – 2.5%.


5. The objective of ETF is to track an index and reduce the tracking error as much as possible. On the other hand, mutual funds, aim to beat the index.


6. You can invest in Index Funds through Systematic Investment Plan (SIP). You cannot invest in ETF through SIP.

While the charges of mutual funds are higher than ETFs, they have the potential to generate higher alphas. Alpha is a measure of the value added by the fund manager relative over the benchmark index, after factoring in the risks taken by the fund manager. If the alpha is higher than expense ratio, it makes sense to invest in mutual funds rather than ETFs, because you will get higher returns than ETFs. On the other hand, if the mutual fund manager is not able generate high alpha, it makes more sense to invest in ETFs

Which is better Mutual Fund or ETF?

It depends on the market. If you read financial literature from developed stock markets like the US, you will come across the observation that, over a long time horizon fund managers have not been to beat the S&P 500 index, the broader market index in the US. If the fund manager finds it difficult to beat the market index, why should you pay higher fees in mutual funds, while you can get the index returns at a much lower cost? However, it depends on the efficiency of the stock markets. Stock markets are much more efficient in the US than in India. Over a 20 year time horizon, here in India, funds like Reliance Growth Fund, Franklin India Bluechip, HDFC Top 200 etc, have given higher than 20% higher compounded annual returns, far higher than what the benchmark indices have given. As our stock market gets more efficient, fund managers will not be able to generate as high alphas as in the past, but we cannot expect our equity market to get as efficient as the US, in the near or the medium term. Therefore, at least in the medium term, it is expected that, mutual funds will continue to outperform ETFs. On the other hand, there are many mutual funds that underperform versus their benchmark indices. In summary, if you are able to select good mutual funds, you will be able to beat ETF returns comfortably. On the other hand, if you are not comfortable about selecting good mutual funds, you can invest in low expense ETFs. In either case, equity market in India are expected to do well in the medium term. Despite the reversal in election results in Bihar, the Central Government is committed to pursue the agenda of economic reforms. The macro-economic fundamentals of India are improving and most experts are of the opinion that we are in long term secular bull market.

Equity Investing versus Mutual Funds / ETFs

Unless, you are an expert in stock picking and market timing, you should avoid directly in share market and instead choose the mutual funds route. Read our article, 7 Key Benefits of investing in Mutual Funds versus directly in shares. If you want to invest in stocks, you should invest in stocks, that will directly benefit from the recovery of the investment cycle in the Indian economy. Banking and finance stocks, automobile stocks, capital goods stocks and consumer durables stocks should do very well with cyclical revival in domestic capital expenditure. You should also balance your equity portfolio with high quality stocks in defensive sectors, like IT and Pharmaceuticals. We will publish an article, with the view of leading brokerage houses on the stocks from different sectors with high potential returns in the coming Samvat, shortly after Diwali.