Mutual Funds Vs ETFs in India – Which one to choose Today, And Which one in Future?

Note – This is a guest post by Girish Sidana, a reader and an accomplished professional working for a well-known name in Indian automobile industry. You can connect with him professional here.
 
So over to Girish… 
 
Most people reading Stable Investor would be fully convinced (even I am) that investing in well diversified Mutual Funds for a reasonably long period fetches the best possible returns. But what if I tell you that this may not remain true in future?
Yes. It may sound surprising.
 
But before I go into the details and tell you the reason for the above statement, let me try and explain the concept of another product, which is bound to play a big role in future. I am talking about Exchange Traded Funds or ETFs.
 
 
What are ETFs?
 
An ETF is very similar to mutual funds (MF) in a way, that it is also a fund of various stocks. It helps investors diversify their investment portfolio. But unlike actively managed mutual funds which charge around 2% as fund management fees, ETFs comes at a very low cost of about 0.5%
 
So how are ETFs able to charge so less?
 
Its because ETFs are not actively managed by fund managers. Rather these mimic the composition and returns provided by various indices. So you can invest in Nifty ETF which will track Nifty and will give returns commensurate to Nifty.
 
ETFs are also traded live on the exchanges. This is quite unlike MFs, which have a declared NAV for each day. Although ETFs have their own set of problems like tracking error, commission on each purchase or sale, liquidity etc., lets keep that discussion for some other day.
 
Here is what National Stock Exchange had to say about ETFs:
 
“In essence, ETFs trade like stocks and therefore offer a degree of flexibility unavailable with traditional mutual funds. Specifically, investors can trade ETFs throughout the trading day as in stocks. In comparison, in a traditional mutual fund, investors can purchase units only at the fund’s NAV, which is published at the end of each trading day. In fact, investors cannot purchase ETFs at the closing NAV. This difference gives rise to an important advantage of ETFs over traditional funds: ETFs are immediately tradable and consequently, the risk of price differential between the time of investment and time of trade is substantially less in the case of ETFs.
 
ETFs are cheaper than traditional mutual funds and index funds in terms of fees. However, while investing in an ETF, an investor pays a commission to the broker. The tracking error of ETFs is generally lower than traditional index funds due to the “in-kind” creation / redemption facility and the low expense ratio. This “in-kind” creation / redemption facility ensures that long-term investors do not suffer at the cost of short-term investor activity.”
 
Note – To know more about ETFs and how they are structured, you can read comprehensive writeups available on NSE’s website (link).
 
Philosophy of Index Formation
 
It is also important to understand how an index is formed. Let us take the example of Nifty 50. It is made of top 50 companies of India. It is a dynamic index and keeps adding and dropping companies based on their market caps and various other factors. So, essentially, Nifty 50 is a good-enough barometer of the top Indian companies.
 
Thus an ETF taming Nifty 50 will give returns of these top 50 companies of India. Logically, this should be the best possible return one can think of. What better than top performing companies and that too tracking them almost on a real time basis?
 
But historical data shows otherwise. We all know (if not all then at least readers of this website) that lots of actively managed Mutual funds in our country have been giving better returns than Nifty (or Sensex for that matter).
 
And since actively managed funds are costlier than ETFs (or index funds), the higher expense will be justified as long as active funds, after accounting for expenses are able to beat the ETFs (and index funds) by a decent margin.
 
 
What Happens in Mature Markets like US?
 
The story in markets like US is very different from that of India. In those markets, most actively managed funds are not able to beat their benchmark indices. So purely from the returns perspective, ETFs make more sense there. 
 
An actively managed fund needs to return at least 2% more than the benchmark index to come at par with ETF. Now for all of you who have understood the power of compounding, appreciating a 2% increase per annum will be lot easier.
 
The reason which I have understood (by reading expert articles on this topic), and even though I don’t agree completely, is that Indian Mutual Fund managers are able to identify hidden stocks which may not be part of an index but are value stocks. Or, to put it differently, Indian stock markets still have nuggets of Gold hidden here and there – and that is because our markets have still not matured enough. And because of this, quite a few Indian mutual funds are able to give better returns than ETFs.
 
The Question / Deduction
 
Now the big question is that as the Indian economy grows and stock markets mature, the hidden value stocks may not remain as hidden as they are now. Also, there may be very few value stocks available over a period of time. This will make the task of Mutual Fund managers a lot more difficult.
 
Based on this logic, my understanding is that in times to come, the gap between returns from an ETF and return from a MF will reduce. And once this starts happening, it will be prudent to invest in ETFs rather than MFs. Or at least it will make sense to start allocating a decent part of your portfolio to a broader ETF like Nifty ETF.
 
Again, to take the example of developed market like USA, the debate of MF vs ETF is pretty hot. The data is very much in favour of ETF but there are equal proponents of both schemes. I remember reading one of the articles which compared this debate to vegetarian vs non vegetarian. Both advocate the merits of their school of thought.
 
Although history tells us that diversified MF are best investment vehicles, the future may be very different. So it might be wise to stay on the lookout for this development and remain cautious. 
 
MF may not be the cure-for-all as it is being told to all of us.
 
Personally, I have started allocating a part of my portfolio to ETFs (apart from the regular SIPs I do in MF). Whenever I see Nifty P/E going below 22, I invest some amount in Nifty ETF. I have started doing this very recently so have not got too many opportunities. My plan is to keep doing this regularly and may also reduce my SIP amount for a given month if I see Nifty P/E going below 20 and put this money in ETF. Or even skip my MF SIP in favour of ETF if it goes below 18.
 
What do you think? Do you think it makes sense to start looking at ETFs a little more seriously in near future?
 
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Written by Dev Ashish

Founder - Stable Investor Investing | Personal Finance | Financial Planning | Common Sense

23 comments

  1. Thanks for the blog . Just wondering , if you could suggest 3 ETFs candidates in India .

    If you look at the assets most of the ETFs manage in India is too trivial compared to the actively managed funds like HDFC Equity / Top 200.

    Appreciate your recommendations !

    Thanks

  2. One of the oldest and most popular (and probably the largest) ETF is GS Nifty BeES managed by Goldman which was earlier Benchmark (Benchmark was acquired by Goldman). It mimics NIFTY50.

    Precisely, ETFs are not popular in India. Lot of it may have to do with consumer awareness. Also, since the history shows that most actively managed diversified equity funds have beaten the underlying index, very few financial planners promote ETF. That is exactly my point. History is fine but future may be different and it may not be easy for actively managed funds to beat index in future.

  3. Agree with you.

    Most of the actively managed funds thrive on the 'stars' from the 'past performance' . But the past performance may not always guarantee future results .

    The expense really matters when it comes to longer term & compounding, time has come to move to passively managed index funds.

    I presume NIFTYBEES is an ideal one to change the direction of the investment journey .

  4. Also instead of investing regularly , what if one park the money in a savings bank account and wait (may be for 1 or two years ) for the Nifty PE to go down 18 and then invest ? How is that when it comes to return?

  5. Rather than parking in savings account, invest in debt funds. Be careful to choose good funds with low exit charges.

  6. It doesn't make any sense in this debate of ETF vs MF..Investor never thinks about daily/hourly fluctuations in price but traders think.
    Another argument of performance of ETF in matured market does not have any facts. Its based on assumption. Even in US market there are value buys. Until there is a fear and greed there will always opportunity for value buyers.

    India has a long way to become mature market.

  7. Hey Thanks for sharing the links . Needless to say it was an eye opener, so it says discipline is the key when it comes to MF

    But MCF still makes sense because if Nifty PE < = 15 one can spot a lot of individual gems at a better bargain rates and buy them
    For the record : I skipped an important meeting today to finish reading your analysis. Thanks for your effort !! God bless !

  8. Dear Vijay,

    I do not have answers to all your questions but what I know of AMCs (MF management companies) is that they are goverened by very strict laws of SEBI and our investments are safe even if the AMC goes bankrupt. The underlying asset is the stock of a specific company which will not be affected by AMC going bankrupt.

    I do not think running a fake ETF is possible. The laws are pretty tight. In fact I believe that MF are governed/regulated more tightly than required.

  9. I value your comments KP. But unclear about your fluctuations comment. I do not think I am anywhere talking of fluctuations.

    Performance of ETF in matured markets is well documented. The point I am trying to make is that most MF in developed markets are not able beat their underlying index. This data is available. So why not invest in the index itself, which will at least come at a much lower expense ratio.

  10. Just out of curiosity : When we discuss about investing based on index PE , what is your call on the high PE stocks in the benchmark index;

    For example the recent induction of Bosch; the one that has a very high PE compared to its peers.

    Doe it mean , If one invests in NIFTYBEES you are forced to buy a ridiculously expensive stock ??

  11. Nice article. I have been wanting to understand more about ETF after I saw some ads recently and chanced upon your article. You have covered good details and brought us to point of thinking.

  12. Girish , Dev

    Just out of curiosity : When we discuss about investing based on index PE , what is your call on the high PE stocks in the benchmark index;

    For example the recent induction of Bosch; the one that has a very high PE compared to its peers.

    Doe it mean , If one invests in NIFTYBEES you are forced to buy a ridiculously expensive stock ??

  13. India has very limited choices of ETFs. Look at developed world they have etf for every sector, every style of investing, every geography and even leveraged and negative Etf.
    I am following a different strategy. Since market PE is high 22-23, I diverted all my SIPs into money market fund. Once I feel the PE is comfortable (either price reduces or earnings increase) , I will use MF switch transaction to ramp up equity in my portfolio. This way I maintain my discipline of SIPing also.

  14. Perfect strategy Anish. This way you will be able to maintain pretty good liquidity as well.

    Yes India has limited choice of ETFs. Once India also reaches (I don't know when) the stage of MFs not being able to beat underlying index, we will also have many ETFs coming to market. But see from an ordinary investor's point of view. He is mostly investing in diversified equity funds, there are ETFs for BSE Sensex and Nifty 50.

  15. In isolation it may not seem to be prudent to buy a very high PE stock but once you invest in a diversified instrument and instrument managers charge a decent fee and you still get returns which are not beating the underlying index, then ETF makes sense.

    And please don't take me wrong, I am not advocating ETF. I am only questioning a belief of diversified MFs giving best possible returns. It may not remain true in future.

    To answer your last part of the question, yes if you are investing in NIFTYBEES, you are forced to buy a ridiculously high PE stock. This is true even for a equity MF.

    PE is not the only indicator of a stocks potential growth.

  16. Thanks Girish. Appreciate it.

    I was only mentioning the price of the derivative one has to pay not the growth factors , where one does not have an option but just to buy.

    I was only hoping that the folks who choose scrips for the indexes will do a fair job. Bosch is just one example.

    Thanks again
    Anil

  17. Very nicely put Girish, I would just add on to this. Just finished reading The Intelligent Investor, the greatest investor of all times (Benjamin Graham) points out that Index funds are one of the best instruments for investing, that way you will never miss the next Reliance, TCS, Infosys, etc. Now coming to returns, even in Indian markets, if we look for best performing mutual funds for last 20 years, I am doubtful if there are any that beat the index. In the shorter term, say 1 year, 3 years, yes, it is easy to beat index, but not in the long term. There are some more advantages for ETFs. Say, you want to trade in US stock markets from India. You can do that by buying Motilal Oswal MOSt Shares NASDAQ 100 ETF

  18. Pingback: Simplifying SEBI's mutual fund Categorization & Rationalization for Investors

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