ETF explained: Should you invest in Exchange-Traded Fund over Mutual Funds or stocks? | Interview

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Updated: Mar 07, 2021 10:13 AM

ETFs have been capturing market share from mutual funds as the management fees of ETFs in India have an expense ratio as low as 0.10% compared to an actively managed mutual fund for which charge is in the range of 1.5% to 3% of AUM

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It requires research to discover a top-performing actively managed fund that might be able to give you a consistent return every year. Despite that, over the years, ETFs have been capturing market share from mutual funds as the management fees of ETFs in India have an expense ratio as low as 0.10% compared to an actively managed mutual fund for which charge is in the range of 1.5% to 3% of AUM, says Nilesh Shah, Chairman and Managing director, Atlas Integrated Finance Ltd.

Shah further says that a 1% additional every year for the next 20 years makes a significant value in increment in the investor’s wealth. Whereas the returns generated by an actively managed mutual fund are largely dependent on the skills and experience of the management. In an e-mail interaction with FE Online, Shah explains the various facets of ETF and why it could be the best option to diversify one’s portfolio. Excerpts:

What are some popular ETFs among investors? And why?

There are six categories of ETFs in India. They are index ETFs, gold ETFs, sector ETFs, bond ETFs, currency ETFs and global Index ETFs. Out of which index ETFs and gold ETFs are the most sought after ETFs and are also the largest based on AUM size. Based on the performance of 2020, NASDAQ ETF and Gold ETF have delivered the highest returns.

Why should one invest in ETF’s instead of stocks or mutual funds? Could you share some data-based inputs?

We all know the old adage “Do not put all your eggs in one basket”. ETFs is the practical application of that. When an investor buys a stock of a company, he/she is taking exposure to only one type of asset class which is equity. Now those stocks can either turn into multibaggers or wealth destroyers. Whereas through ETFs an investor not only gets exposure to the top companies in terms of market capitalisation but he/she can also invest in bonds, currencies, commodities etc.

Thus ETFs provide diversification and better risk-adjusted returns. Investment is made in the NIFTY 50 ETF and NIFTY NEXT 50 ETF have given a risk-adjusted annualised returns of ~11.6% p.a. and ~13.2% p.a. respectively.

Who should invest in ETFs?

ETF investing is suitable for those investors who have limited time to analyse individual companies, limited investible corpus, limited financial literacy and who wish to have a diversified portfolio. Such investors are protected by ETFs during volatile times as the drawdowns seen in an ETF is likely to be less sharp compared to direct investing in stocks. ETFs also enable investors to invest in different asset classes like gold without having to worry about storage issues, security issues and rolling over the gold futures contracts.

Over the last 10 years, over 50% of the fund managers have failed to generate any substantial amount of alpha and some of the well-known large-cap mutual funds have underperformed. But with ETFs we have a proven track record of consistently generating a 16% CAGR annually and no problem of relying on somebody else’s talent.

ALSO READ | Exchange Traded Funds: Check out advantages of investing in ETFs

Explain the difference between an ETF, MF and Index Funds

To purchase a unit of mutual fund you have to place a request with the fund house to do so. But ETFs are freely traded in the market and can be bought and sold as per the investor’s convenience. Their market price is available in real-time just like ordinary equity shares unlike Mutual funds where the NAV is available at the end of the business day.

Since ETFs trade throughout the day and provide ample liquidity compared to mutual funds, it is most preferred by short and medium-term investors. One can place a stop loss orders on ETFs to protect against a sudden crash.

The minimum amount required to invest in an ETF is usually lower. Investors can buy as little as one share in an ETF, which is usually not possible in index mutual funds. Index funds require a minimum investment of Rs.100 both in case of lump-sum or SIPs. However, the amount varies across funds. Investors can sell short or buy on margin.

Compared to Index funds, ETFs have a lower expense ratio because index funds just like mutual funds have a higher amount of administrative and operating expenses compared to ETFs.

What kind of investment strategy should investors look into while investing in ETF?

As ETFs can be traded just like stocks, one can use the same strategies in ETFs as one uses while trading stocks in the cash markets. For traders and short term investors some of the strategies include swing trading ( which involves buying low and selling high) and sector rotation ( investing in sectors that you are bullish on). For long term investors, a Systematic Investment Plan (SIP) is one of the easiest and most effective ETF investing strategies. When you carry this ETF strategy out for a reasonably long period of time, the overall cost of your holdings will automatically be averaged out and help you earn a higher percentage return.

Why should one diversify when investing in ETF’s? 

Every asset class has its own advantages. Equities have proven to be massive wealth generators over a long time, while debt has been a source of earning a fixed income. Gold on the other hand has a very low correlation with debt and equity and provides a hedge against inflation and a crashing stock market.

Let us take March 2020 as an example. Due to the pandemic and the resulting nation-wide lockdown, the equity markets crashed by approx. 24% with individual stocks crashing even more than 55%. However, in that month gold delivered a positive return of 2.5% and continued to rise thereafter reaching a record high level. Thus for an investor who was equally invested in equities and gold would have his portfolio down by a mere 11%, thereby saving his wealth erosion by more than 50%. Thus ETFs are a great way to diversify your portfolio and hedge these risks while still keeping some upside.

In the current scenario as the valuation of most stocks is at nosebleed level, diversification through ETFs can be used in such scenario. For Atlas Dynamic ETF PMS, which is our hybrid ETF fund, we have allocated around 30% in equities, while 30% and 40% allocation is made towards gold and liquid funds respectively. However, one can increase or decrease their allocation towards their risk and return expectations from a particular asset class.

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