Why you should invest in ETFs?
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An exchange traded fund or ETF is a financial instrument that invests in a basket of stocks that reflects the composition of a market index, e.g., Sensex, Nifty, etc. ETFs are listed on stock exchanges and are traded like shares of companies. Unlike active mutual funds, ETFs do not aim to beat the index; they aim to track it as closely.
Benefits of Exchange Traded Funds
There are several benefits of Exchange traded funds compared to actively managed mutual fund schemes.
- Equity investments have two kinds of risk: systematic or market risk, unsystematic or stock-specific risk. Actively managed mutual fund investments have both systematic and unsystematic risks. Actively managed schemes of the mutual fund have unsystematic risks because they are usually overweight or underweight on some stocks versus the benchmark index. While being overweight or underweight on certain stocks can help the fund manager create alphas, it can sometimes result in underperformance against the benchmark index. ETFs are not overweight or underweight on any stock. There is no unsystematic risk in ETFs. Stocks in the ETF basket have the same weight as those in the index. ETFs are subject only to systematic or market risk.
- Fund managers of actively managed mutual funds may have subjective biases. Fund managers are human beings and, like any other human being, can make errors of judgment. There is no human bias in ETFs. An exchange traded fund will not have a subjective bias towards any stock – the stock will have the same weight in the ETF as it has in the market index.
- Another benefit of ETF is that there is very little fund manager dependence. The fund manager is attributable to the over or underperformance of actively managed mutual fund schemes. Changes in mutual fund managers can impact the performance of the mutual fund investment. On the other hand, a change in fund manager will have minimal impact on ETF performance.
- ETFs’ expense ratios (TER) are much lower than actively managed mutual funds in India. The fund manager of an actively managed fund will have to generate significant alphas consistently to match the performance of a passive fund tracking the same benchmark index. Lower costs over long investment horizons may help you get considerably higher returns due to the compounding effect.
- Another advantage if you invest in ETF is that outperformers get higher weights in the market capitalization-weighted index, i.e., if the market cap of a stock increases more than that of another one, the weight of the outperformer in the index will increase more relative to the other one. ETFs tracking market capitalization-weighted indexes like Sensex or Nifty will reward the outperformers. Actively managed mutual funds in India may be restricted in concentration risk mandates for particular stocks.
ETFs are extremely popular in developed economies. They are getting increasing popularity in India also. ETF has been one of the fastest-growing mutual funds in India categories over the past few years.