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Why ETFs May Not Be The Right Choice

ETFs, or Exchange Traded Funds, are an effective vehicle for investing in a basket of securities, particularly Equity. Financial advisors…

ETFs, or Exchange Traded Funds, are an effective vehicle for investing in a basket of securities, particularly Equity. Financial advisors often recommend investing in an ETF such as Nifty ETF. This is particularly true in the US and the developed world. However,  ETFs may not be the best way to invest in India, at least as of now. To understand why, let us understand the difference between an ETF and other Equity mutual funds, such as the funds picked by Jama under the Wealth Builder category.

How does ETFs work?

An ETF is simply a passive fund. In other words, there is nobody managing the fund! For example, if you invest in a Nifty ETF, your money is  invested in the 50 stocks that constitute the Nifty, in exactly the same proportion as per the weightage of each stock in the Nifty. The net effect of such an investment is that your investments grow at (almost) the same rate at which the Nifty grows. For example, if the Nifty was at 8000 when you invested in Nifty ETF and is now at 8800, chances are your investment has also appreciated by 10%.

It is quite possible that in a given situation, a particular sector, say Pharma, may be going through some tough times. You may not really want to invest in pharma stocks at that point in time. However, the ETF does not give you such a choice. A part of your investment is in Pharma stocks as such stocks are part of the Index. This is what we mean by passive investment. You do not do anything to your investment and let it be! Over a period of time, different sectors will go through their business cycles and the Index will earn you decent returns. The Nifty has given annualized returns of 11% plus since its inception in 1996. At 11%, you are comfortably beating inflation and creating a real surplus for meeting your financial goals.

How do other funds work?

However, a large number of funds whose benchmark is Nifty, have done relatively much better. These funds are actively managed by a fund manager who is continuously looking at the prevalent scenario, anticipating future changes, identifying which sectors and stocks would do better and invest in such stocks. Such funds are called Actively managed funds. In our example, if a fund manager believes that Pharma industry is going through a rough patch, he/she might want to get out of such stocks and re-enter them after the situation has stabilized or improved. In other words, a knowledgeable expert is on the job of managing your money in what he/ she thinks is the best way to do it. Where would you feel more comfortable?

Investing in a passive fund is to leave things to chance, hoping that they would change for better over the long term. Active funds monitor the situation and seize the opportunities offered by the market.

So, why are ETFs recommended?

Since ETFs are not actively managed, you do not need to pay huge amounts to the fund manager for not doing anything. Thus, the charges of a passive fund are much lower than the charges of an active fund. You can check the TER (Total Expense Ratio) of actively managed funds vis a vis Passive funds and find that active funds charge close to 1.5% (of AUM) extra. In other words, if you invest Rs.100,000, you will pay Rs.1500 more annually to the fund because you are utilizing the services of an expert.

Also, many experts opine that it is best not to tamper with the investments. Each sector and the stocks will have its journey of highs and lows, which ultimately even out. The fund manager may unnecessarily churn the portfolio and increase operating costs, which are ultimately borne by the investors.

Lastly, sticking to the index stocks offers an element of safety. The stocks that constitute the index are bellwether stocks, arguably the best from a diversified group of industries. It is high unlikely (though not impossible) that these companies get closed down or get involved in scams. Most, if not all, will do well in the long run. Thus, index stocks are like “tested, trusted and guaranteed” products. You can’t go too wrong with them.

What does the experience of other countries suggest?

If we look at the US, you will find that ETFs have done better than most actively managed funds. In fact, I would advise any investor to stick to the ETF rather than invest in actively managed funds.

Then Why is it different here in India?

Like it or not, Indian markets are far from efficient. It offers a lot of opportunities for the diligent fund manager. Funds making investments in stocks based on solid research are likely to beat the Index handsomely. The US markets are far more efficient and it needs extraordinary efforts on part of a fund manager to consistently beat the markets.

Do you trust the capability of the fund manager?

One of the reasons why we invest in mutual funds is our belief that a knowledgeable expert will be able to take investment decisions much better than us. If that is the case, then we need to place our faith in his/ her ability to read the market and act decisively. The moot question is whether the actively managed funds are giving superior returns than the index.

Too much fuss is made about the expense ratios. Remember that the returns earned by the fund are after adjusting for the Expense ratio. Thus, if an active fund is yielding a return of 14% vis a vis an index return of 11%, you still get 3% extra AFTER paying the fund manager. You pay the fund manager because of his/ her ability to generate superior returns.

ETFs

 

As regards saving on the TER, you are already doing it on the Jama platform by investing in Direct mutual funds. The TERs of Direct funds are much lower than that of Regular funds. You do not compromise in any manner. You save by eliminating the broker/ commission agent who is recommending the Regular funds to you.

Conclusion

It makes sense to invest in actively managed funds in India. Choose any of the Jama picks, invest always in Direct plans and see your money grow. Every single percent matters and makes a huge difference!

Happy investing!

 

 

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