Anil Rego
Right Horizons
Mutual funds are one of the best ways to invest one’s money. Given the sheer number of choices catering to every type of investor preference, the fact that one need not monitor the investments on a minute-to-minute basis (unlike if one’s investments were directly made into securities), and the ability to diversify one’s portfolio without high initial capital makes this venue attractive.
Within the mutual fund universe, index funds are one of the best -- though under-used -- products. These funds typically follow the index (either the Sensex or Nifty), by investing in the stocks constituting these indexes in the same proportion, and since they are not actively managed (these are passively managed funds), the cost structure is lower.
As a trade-off, one can only get market returns and will not beat the market in any year, but at the same time there is no sectoral or fund management risks in these funds.
There are two ways to invest in an index fund, either through a mutual fund or via an exchange traded fund (ETF). Both are very similar in their constitution and returns, however the method of operation is different, with active investors preferring ETFs since these can be traded through the day, while passive investors prefer index mutual funds.
Index mutual funds offers investors a low-cost alternative to actively managing their own portfolio, with minimal activity and portfolio churn. Through this method, one can enjoy diversification of one’s investment portfolio, the portfolio risk is reduced, and one can get either a steady flow of income or capital appreciation in the short or long term (depending on one's investment horizon and goals) through a diversified portfolio at a low cost and low risk.
An exchange-traded fund allows an investor to operate with a directional view on the market. Units of the ETF are traded like a stock on a stock exchange but operate similar to mutual fund.
This provides investors a mix of the diversification, and professional management of the mutual fund, along with the ability to trade in these units on a daily, weekly, monthly, etc. basis.
Active investors will be more comfortable with ETFs since their prices are more volatile than index mutual funds.
Trading of units
Buying and selling units of an ETF is done through a brokerage account for which the investors have to pay brokerage commissions and other charges. Investing and redemption of mutual fund units can be done through a mutual fund broker, and for an index mutual fund, there is typically no entry and exit load.
Taxation
As far as tax efficiency is concerned, both an ETF and a mutual fund will be taxed similarly since they are both equity investments. There will be a 10% capital gains tax on short term investments (less than one year) and no tax on long term investments (over a year). However, the ETF will be subject to other taxes such as STT, service tax, etc. since this is traded on the stock market.
Price volatility
The volatility in the prices of the index mutual fund and index ETF is another matter to consider. The price of the index mutual fund does not fluctuate during the course of the trading day, it is typically priced (i.e. NAV is calculated) once a day - after the markets close.
On the other hand, an index ETF’s prices fluctuates through the trading day. This leads to more price volatility in the ETF prices as compared to a regular index mutual fund. However, if one invests in an index ETF for the long term, then the price volatility will not have substantial impact.
Schemes
An index mutual fund offers two options, one can either choose a dividend option (either payout or to reinvest the dividend income in to the mutual fund), and a growth option.
However, in the case of an ETF, although the options are similar, there is no automatic dividend reinvestment option. Hence, dividends are paid to the investor, who then needs to reinvest this - resulting in reinvestment risk and higher costs.
Conclusion
Both options for investment into index funds are similar while having differences to suit investor preferences.
A mutual fund is ideal for those looking for passive investment modes, and are not able to monitor the prices on a daily basis, and are looking to hold their investments for the long term.
On the other hand, investors who are looking for short to medium term returns, have more risk taking ability, and have the time and capability to monitor prices on a daily basis, will prefer an ETF.
It is advisable to invest in a mutual fund via a SIP (systematic investment plan), to avoid timing the market, since at times of rising markets one gets better prices and in falling markets one gets more units.
This is an effective risk management tool, and one can get better returns using this method. However, a SIP is not available in ETFs, and one should take care while entering the markets as timing becomes more crucial.
Summary:
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