Mutual funds are a pool of actively and passively managed funds that aim at wealth creation for its investors. For those who might not know, mutual funds offer both active management and passive management strategies. Actively managed funds are those mutual fund schemes where the fund managers actively work the fund’s portfolio. They are the decision makers who decide which stocks to invest in, which supplies to hold on to, and which stocks to sell. When it comes to passive funds, the fund managers have a minor role to play. They ensure that the fund’s portfolio remains aligned in the same way as those of the stocks that comprise the underlying benchmark.
ETFs are passively managed funds. Also referred to as exchange traded funds, they invest a minimum of 95% of their investible corpus in the underlying index/benchmark.
Here are a few factors to consider before investing in Exchange Traded Funds –
Are you in for passive investing?
Passive investing is not for everyone. Not everyone can carefully study the equity markets to make an informed investment decision and hence consider mutual funds instead. Remember that most investors start their investment journey with mutual funds is because mutual funds offer active risk management. Mutual funds have dedicated portfolio managers who ensure that the scheme’s portfolio remains aligned with the investment objective. On the other hand, few investors do not like the idea of their portfolio being fiddled now and then. Some investors are uncomfortable with their investment portfolio being reshuffled from time to time. Such individuals who do not want their returns to be influenced by human biases may prefer a passive investing style. Hence, investors must first understand if they will follow an active or passive type of investing.
What type of ETF are you considering?
There are various types of exchange traded funds that investors can choose from. Suppose you want to invest in an ETF that explicitly explores foreign markets, then you need to invest in an international ETF. Suppose you want to invest in an ETF that tracks an index for income generation, then you can invest in an index ETF—those who wish to invest in ETFs that track debt related instruments can consider investing in bond ETFs. If you are looking for an ETF that invests in multiple ETFs to achieve its investment objective, you can invest in a Fund Of Fund ETF.
The returns generated by exchange traded funds are subject to tracking errors. While other mutual funds try to outperform their benchmark, ETFs replicate the performance of their underlying model instead of beating. They do so by generating returns similar to that of the portfolio. While doing so, there can be complications as the portfolio composition of stocks that comprise keeps rejigging. Thus, tracking errors may result. Investors must consider an ETF with low tracking error.
Total Expense Ratio
One major reason why several investors prefer passive funds like ETFs over active mutual funds is that they have a relatively low expense ratio. An expense ratio is nothing but the recurring expenses like management costs operational and other administrative costs, which the AMC has to bear to ensure the smooth functioning of the scheme. They recover these costs through expense ratios that investors have to pay. Since ETFs adopt a passive investing style, the fund manager has very little say in how the scheme will generate returns. The passive investment style attracts a low and feasible expense ratio for ETF schemes.