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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One of the Biggest Reasons You should be Investing. Even if you can’t beat the Markets.

Surprised?

I am asking you to invest, knowing very well that most of you may not be capable of beating the markets regularly.

Let’s be honest here. Most investors haven’t been able to beat markets consistently over long periods. I am not talking about greats like Buffett. I am talking about common people like You and me. People who have an intention of making a killing in markets, but somehow or the other, end being killed by the markets.

But if you know that you cannot beat the market, then does it make any sense to be in market?

Yes it does.

But first and foremost, please understand that accepting and embracing the fact that you are incapable of beating markets is an achievement in itself. 95 out 100 people in markets do not know this or don’t want to accept this. But it is the hard truth and tough to swallow.

But…if you are ready to accept this uncomfortable truth, then it can be one of your biggest strengths in stock markets. 

Market has an unbelievable potential of creating wealth. On an average, markets deliver annual returns of 12% to 15% over long term.

For someone who is capable of beating these numbers, returns would be in excess of 15%. But for those who are not in markets, all they can possibly earn is 7% to 9% depending on taxes applicable on the chosen asset class like banks deposits, etc. By not investing in markets, these people are missing out on extra 3% to 5% which can be earned by staying in markets.

Now these might look like small single-digit numbers. But you will be shocked to see the effect these numbers have on your wealth over a period of 10-20 years.

And the graph below clearly shows this. It’s a very simple depiction of what happens when an annual investment of Rs 60,000 (5K Per month) grows at 12%-15% (Equities); and what happens when the same money is parked in safer options at 7%-9% (FDs, PFs, etc).
Monthly Investment 20 Years
Returns on Rs 5000 per month investment in 20 years (At 7%, 9%, 12% and 15%)
Over a period of 20 years, you would have put in Rs 12 Lacs, i.e. Rs 5000 every month. Now this can either grow into Rs 26 to 34 Lacs if invested at 7% to 9% class of assets. Or into a much bigger amount of Rs 48 to 71 Lacs if invested at 12%-15% in stock markets.

Now wait…if you think that markets guarantee 12%-15% every year, then that is not the case. Returns in market are volatile. It can be 50% in one year and (-)30% in another. But over long periods spanning decades, the average returns are in line with these numbers.

And this clearly means one thing…

Even if you cannot beat the market, you should still not avoid investing in it.

Avoiding markets would prevent you from achieving higher long-term returns when compared with other options like bank deposits, PF, etc.

So is there a way to invest in markets, which is…

1) Simple
2) Sensible
3) In line with the thought that it is not easy to beat markets?

The answer is yes.

And the way to do it is Index Funds.

What is an Index Fund?

According to Investopedia, Index Fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index (such as Sensex or Nifty 50). An index fund is said to provide broad market exposure, low operating expenses and low portfolio turnover.

You might not know which individual stock or sector will outperform. But on an average, a carefully selected group of companies across sectors can do a decent job of maximizing diversification and minimizing exposure to few individual companies or sectors.

I am not saying that you should invest all your money in index funds. But if you think you want to save (invest) for long term, then atleast a part of your money should be parked in instruments linked to stock markets. And your safest bet can be Index funds. You can also choose well diversified large-cap or multi-cap funds which have proven track records. But that would mean that returns achieved by such funds would depend on fund manager’s ability to pick stocks. On the other hand, there is no active selection of stocks in index funds. Such funds simply replicate the composition of an index.

So if you feel that you have a knack of picking stocks which give market beating returns, then there is nothing like it and you should surely invest in stock markets directly.

But if not, then may be its time to think a little more seriously about Index Funds. And that is because if you are not in markets, then over long periods, you are missing out on some seriously big wealth creation opportunity.

Interesting Story:

When Google was about to launch it IPO in 2004, the company realized that this would create quite a few millionaires among its employees. The company therefore brought in a series of financial experts to teach them to make smart investment choices. A 1990 Economics Nobel Prize winner was also brought in. Even he advised Google employees “[not to] try to beat the markets” and to park their money in index funds.

Seems like Someone has rightly said – If you can’t beat them, join them. 🙂

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