Understanding The Various Funds

One of the major confusions arises in their mind is about the difference between mutual funds, exchange traded funds and index funds. At first glance, all seem to be the same as they share similarities between each other and invest in similar set of instruments. Nonetheless, there is a great deal of difference in the way they are managed

The rise and acceptance of mutual fund products in India has been exceptional in the last few years. However, investors are still confused about seemingly similar products offered by them. One of the major confusions arises in their mind is about the difference between mutual funds, exchange traded funds and index funds. At first glance, all seem to be the same as they share similarities between each other and invest in similar set of instruments. Nonetheless, there is a great deal of difference in the way they are managed.

Mutual Funds

Mutual funds are actively as well as passively managed and offer a wide variety of schemes to their investors. They offer diversification by investing in different asset classes like stocks, bonds, indices, government securities, etc. These funds can be bought when the market opens but get executed at the next available net asset value (NAV), which is determined when the market closes. Mutual fund houses charge you fees which can vary from 0.1 per cent to 2.5 per cent of your investment amount. The expense ratio (fees) is higher when funds are actively managed whereas it is lower when the funds are passively managed (for example, index mutual funds). For instance, if you invest Rs 1 lakh then you will have to pay around Rs 2,500 (2.5 per ent of Rs 1,00,000) to the fund house to manage your money.

Moreover, the expense ratio for debt funds is lower than the equity-dedicated funds. Besides equity and debt there is another category that invests in both equity and debt. These types of funds are known as hybrid funds. So, a mutual fund gives you the opportunity to invest your money in different products, which helps you to achieve different types of financial goals. A mutual fund is a larger set which offers both actively and passively managed funds. Among passively managed funds there are two types: one is an index fund and another is exchange traded fund.

Index Funds



Index funds are the type of mutual funds which imitate the portfolio of an index. These types of mutual funds are passively managed as professional managers have no active role in selecting the securities and formulating the strategies. Index funds buy all the stocks in the same proportion. For example, if the underlying index is Sensex which consists of 30 companies then the fund manager will match the Sensex portfolio and invest in the same 30 companies’ stocks in the same proportion. Generally, index funds have lower expense ratio as compared to actively managed mutual funds which ranges lower than 1 per cent similar to ETFs. Index funds generate similar returns as benchmark indexes; sometimes there can be a difference of returns which is known as tracking error. As per NSE, in India there are 37 mutual funds offering index funds. 

Exchanged Traded Funds (ETFs)

Exchanged traded funds are generally passively managed funds, which can invest in various asset classes such as equity, debt and commodity just like mutual funds. ETFs share the features of mutual funds as well as stocks. ETFs are nothing but index mutual funds which are traded on the stock exchange and can be bought and sold anytime during the market hours like any other stock of the company. ETFs pool the capital invested by the investors in various asset classes like shares, bonds, etc. These funds track the indices and generate similar returns like benchmark indices. These have lower expense ratio as they are passively managed. ETFs have an expense ratio of less than 1 per cent. For instance, if you invest Rs 1 lakh then you will have to pay only Rs 100 as an expense ratio. Nonetheless, you will have to bear the additional expense of trading and demat charges.

In India there are 108 ETFs (11 gold ETFs and 97 other ETFs which track various equity indices and debt indices) with total of Rs 3.15 crore of assets under management as of May 2021, which have seen a spectacular rise in the last five years. There are even some actively managed ETFs known as Smart Beta ETF. Now what is a Smart Beta ETF? These types of ETFs are quite different from traditional ETFs which track the index. Smart Beta ETFs are rule-based, which follow a systematic approach in choosing stocks from a particular index.

As these are actively managed funds, these are managed by professional managers who select the stocks for a portfolio from the benchmark index on the basis of fundamental metrics. Smart Beta ETFs are just factor funds or funds that are alternatively weighted indices (for example, equal weight index, factor-based, fundamentally weighted) unlike Nifty 50 which is market-cap weighted. Smart Beta ETFs offers better diversification and returns as well. Following are some of the top four ETFs based on five-year return and AUM 

The following graph shows the growth in the AUM of mutual funds and ETFs over the last 10 years. 

Conclusion : We saw the differences as well as similarities between investment instruments offered by mutual funds. Each instrument has its own pros and cons. Before investing in any of these funds investors should assess their risk profile, financial goals and needs and according to that investors should choose to invest in these instruments. The index fund is more suited to an investor who does not have the time and knowledge to actively manage the portfolio and is a long-term investor. Such as investor can assign such investment (index fund) as part of the retirement fund. Nonetheless, ETFs are suitable to a sophisticated investor with good knowledge of the market and seeking higher returns