Part 7 of the Classroom series on mutual funds explains the different types of funds and what you should keep in mind before picking up the one that suits your needs.
Q. What is an Exchange Traded Fund (ETF)? What are the pros and cons of investing in an ETF?
A. It is a passive mutual fund scheme, the units of which are traded on a stock exchange. It seeks to replicate the index to which it is benchmarked. The rest of the functioning of an ETF is like any other mutual fund scheme. As units are bought and sold only on the exchanges, investors require a demat account and securities trading account to invest in an ETF. The investor has to pay the brokerage while buying and selling the units of the ETF.
An ETF will have a relatively lower expense ratio compared to a regular mutual fund scheme.
In general, the traded volumes of ETF units in the exchanges are fairly low. Therefore, ETFs are subject to liquidity risk. There is a chance that the units of the ETF may not trade at the net asset value (NAV) due to the paucity of liquidity, which affects price discovery.
Q. What is an index fund? How does it differ from a diversified equity fund?
A. A scheme tracking an index is termed as an index fund. A fund manager is mandated to buy all stocks (components) of the index in the same proportion as they are in the index. The idea is to generate the same returns as that of the index before expenses and tracking errors. Tracking error is the difference in the returns of the index fund and the underlying index. The index funds track popular indices such as Nifty, Sensex, Nifty Next 50 and Bank Nifty.
The fund manager of the index fund does not use his discretion while choosing the stocks in his portfolio and passively replicates the index.
An actively managed diversified equity fund has the potential to outperform the benchmark index if the fund manager gets his calls right. In case the fund manager picks stocks that end up underperforming, the fund lags the index.
Q. What are the pros and cons of investing in an index fund?
A. An index fund is a low-cost scheme. The expense ratios of index schemes are much lower compared to those of actively managed funds. An index ETF may charge you an expense ratio of 10 basis points. An actively managed fund may charge 2 percent or more. A lower expense ratio can add to your returns.
Index funds are free of fund manager risk. They offer market returns and hence the investors can pick one with low cost and low tracking error.
Q. Index funds and ETFs appear similar to me? Which one should I go for?
A. Units of a mutual fund can be bought or sold through online and offline channels as well as on the exchanges. Funds that are exclusively transacted on stock exchanges are termed as exchange-traded funds (ETF).
If you are looking for passively managed fund mimicking an index, go for an index fund. If you are looking for an index fund and want to further reduce the cost, have a demat account and can transact through a stockbroker, you should opt for an index ETF provided liquidity is good for the units of a fund.
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