The confusion lies right here, in the title. When people wonder whether to choose ExchangeTraded Funds (ETFs) or Mutual Funds, it is like wondering whether to choose an iPhone or a smart phone. All iPhones are smart phones but not all smart phones are iPhones. Similarly, all ETFs are mutual funds but not all mutual funds are ETFs.
The real question then is whether to choose ETFs or actively managed equity mutual funds. Because that is what sets an ETF apart from the rest of its mutual fund peers (except index funds). An exchange traded fund or ETF is passively managed equity fund which means that it simply tracks an index or benchmark by mirroring its components and matching its performance with that of the index. In other words, the fund portfolio is like a copy of the index it tracks. The fund will invest in the same stocks as the index so that it mirrors returns generated by the index. Since this type of investing requires very little oversight by a fund manager, i.e, it is not actively managed by a fund manager, it is called a passive fund.
On the other hand, an actively equity mutual fund needs a fund management team that consistently monitors stocks and their performance, the buying and selling of securities of the funds and the daily management of the fund.
To know which is more suitable for you as an investor, let us first understand what an ETF is and what are the other factors that set it apart from an actively managed equity fund.
What are ETFs, and how do they work?
As mentioned earlier, ETFs are mutual fundsthat track a stock exchange index such as the S&P BSE Sensex, NSE Nifty, BSE IT, among others.They hold stocks in the same weight as the underlying index.For example, if the NSE Nifty constitutes 10% of stock X, then the NSE Nifty-based ETF will also hold 10% of its assets in stock X. ETFS are listed on stock exchanges and traded like stocks and offer investors an opportunity to gain exposure to the broader index in a relatively more convenient manner and at a comparatively lower cost.
These are the main features of an ETF:
- Passively managed: Fund managers do not manage ETFs actively. They just track the index performance, making minor, periodic adjustments to keep the funds in line with the index.
- Real-time access: ETFs are traded on public stock exchanges. You need ademat account for investing in an ETF. You can transfer, buy, and sell ETF mutual funds in real-time all through the trading session. The prices change throughout the day. It is up to you to decide when you want to buy or sell your units based on the market conditions.
- Low-cost: ETFs do not need active fund management and, thus, do not involve high management costs.
- Liquidity: ETFs feature no minimum holding periods. If you need quick access to cash in emergencies, these funds can be useful.
Which one to choose – Active or Passive?
You need to assess your risk-bearing capacity, investment time horizon, liquidity needs, and financial goals to select between the two.
If you have limited knowledge of the equity market, then active funds would be ideal. However, if you are a little bit more comfortable with the market movements and would prefer a low-cost product, then you could invest via ETFs. However, from the point of view of diversification, it would be best to have both active and passive funds in your portfolio to maximise the return potential of your portfolio. For those not very familiar with ETFs, to start with, they could consider investing in ETFs that track broader market indices such as Sensex and Nifty.
Whether you choose active or passive funds, investments in equity fund must be for the long-term.