Passive equity mutual funds mirror the composition of a specific index. In an actively managed equity scheme, a dedicated fund manager focuses on stock selection and portfolio management. Passive funds are now gaining ground across categories.
Broadly, passive schemes are of two types: exchange-traded funds or ETFs and index funds. Dig deeper and you would get more variety. ETFs and index funds tracking the S&P BSE Sensex or Nifty are most popular. Then there are smart beta index funds or ETFs. There are thematic schemes, too. Passive funds have become popular globally as well as in India.
Also read: Moving beyond Sensex and Nifty: How ETFs and mutual funds are mimicking newer indices
The large-cap equity category has roughly 50 ETFs and 35 index funds. Gold funds have long used the ETF structure and now we are seeing its use in international schemes category, with the recent launch of the NYSE FANG ETF by Mirae Asset India. Both ETFs and index funds have their unique set of advantages and drawbacks, which you need to filter out before deciding the avenue to invest.
Passive funds are gaining ground because of their low costs. In the absence of a fund manager for portfolio construction and management, costs fall significantly when compared with those of their active counterparts. There are large-cap equity ETFs with annual expense ratios of as low as 0.05 percent to 0.07 percent. In comparison, actively managed equity funds have annual expense ratios ranging from 1 percent-2.25 percent a year.
Index funds are cheaper than actively managed schemes; annual costs can range from 0.30 percent to 1 percent.
Cost is an important measure, because the return you make is net of this expense. In this respect, ETFs score much better than both index schemes and actively managed equity funds.
Also read: How direct plans of index funds score over ETFs on costs
ETFs have the advantage of being traded on stock exchanges in real time. So, you can buy and sell ETFs on stock exchanges such as the NSE and BSE, through your registered broker. Index funds on the other hand are not traded on the exchanges and can be bought like regular mutual fund units. ETF transactions can be made anytime and are immediate. Index fund units can take up to three days for allocation.
Just because ETFs are available on the stock exchanges, you may not get to buy them easily. It all depends on liquidity. For your desired quantity, there need to be sellers in the market. And also willing to sell at a price as close as possible to the scheme’s net asset value. At present, only a few large ETFs have enough liquidity. For example, earlier this month, the UTI Sensex ETF had just 22 units traded on a particular day. What if you wanted to buy or sell more?
When you apply to your fund house for units of index schemes, the request will always be accepted and you will get allotment.
On the BSE exchange platform, 20-25 equity ETFs get traded on a working day and only a handful have volumes in excess of 5000 units on an average. This lack of liquidity in ETFs is the biggest cause for concern when it comes to investing in those. It is what market participants refer to as low liquidity. The fund house may have the facility of a market maker who can step in to buy your units in case of low liquidity when you want to sell. However, this is not a smooth transition of assets when you need it. Research well and buy ETFs that are quite liquid.
For ETF investing, you need a demat account. If you don’t have a demat account, then stick to index funds.
Over the last three to five years, barring one or two actively managed large-cap equity funds, ETFs and Index funds have outperformed the large-cap category. This shows that there is merit in long-term investing through passive funds, especially in the large cap category. When your investment horizon is more than 7-10 years, picking the most cost-effective ETF is what makes sense, provided you have a demat account. Immediate liquidity requirements are better addressed through index funds.