Over the last few years, especially since the outbreak of the COVID-19 pandemic, there has been increasing interest in exchange traded fund (ETFs) among retail investors. ETF is now the largest mutual fund category in India with more than Rs 5 lakh crores of assets under management (AUM). With more than 11 crore demat accounts in India (source: NDTV, 31st January 2023), the potential of ETFs is huge. However, there are large numbers of retail investors in India who do not have sufficient awareness about ETFs, even though they may have invested in mutual funds.
Is ETF a mutual fund?
Many investors think ETFs and mutual funds are different products altogether. Although there are significant differences between ETFs and regular mutual funds, ETFs are essentially mutual fund schemes. Both mutual funds and ETFs are managed by asset management companies (AMCs). Most AMCs have both regular mutual funds and ETFs in their product portfolios. Before we discuss the similarities and differences between regular mutual funds and ETFs, let us understand what an ETF is for the benefit of investors.
What is ETFs?
Exchange traded funds or ETFs are passive schemes, which invest in a basket of securities constituting a market index. Unlike actively managed mutual fund schemes, ETFs do not aim to beat the index, they simply aim to track the index as closely as possible.
Mutual funds and ETFs similarities
Both mutual funds and ETFs are pooled investments. In pooled investments an AMC will take investments from large number of investors and create a financial product or scheme. The scheme will invest in certain type of securities e.g. equity, debt, commodities etc based on the mandate of the scheme. Both mutual funds and ETFs are managed by professional fund managers. However, the nature of fund management of regular or active mutual funds and ETFs is different. Both mutual fund investment and ETFs offer diversification benefits of investors; diversification reduces risk for investors.
Mutual funds and ETFs differences
- You need to have Demat and trading accounts to invest in ETFs. Demat accounts are not necessary for investing in mutual fund schemes.
- Actively managed mutual fund schemes aim to beat the index, while ETFs track the index. In order to beat the index, active funds have to be overweight / underweight on certain stocks / sectors relative to the benchmark index.
- Actively managed funds have unsystematic risks because these funds are overweight / underweight on certain stocks / sectors relative to the benchmark index. There is no unsystematic risk in ETFs.
- Total Expense ratios (TERs) of ETFs are much less than TERs of actively managed mutual funds. Over long investment horizons, lower costs may result in considerably higher returns due to the compounding effect.
- Mutual fund units can be redeemed with the AMC, while ETF units can be sold only on stock exchanges unless you are transacting in lot sizes (creation units) specified by the AMC. Since ETF units will have to be sold in stock exchanges (unless you are selling in lot sizes), you need to have sufficient liquidity i.e. large number of buyers for your ETF in the market.
- Mutual fund transactions (buy / sell) take place on basis of end of day NAVs, while ETF transactions take place on the basis of current bid ask prices (buy / sell offers) in the market (stock exchange) like stocks. In extreme market conditions, the market price may have significant differences with the ETF NAV, especially for less liquid ETFs.
- You should understand these differences and make informed investment decisions based on your own financial needs.