ETFs vs mutual funds: What to pick?

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The investment marketplace is full of options, each more attractive than the other. The question really is this: how do you earn the best possible returns by taking the least amount of risk and by paying the lowest possible costs? One of the best ways to create wealth is by investing regularly in the securities market. Some prefer to invest directly in equities. Other prefer funds, which can be managed either actively or passively. Both options have pros and cons. How does one decide what’s best?

Active vs passive funds

Exchange Traded Funds (ETFs) and mutual funds are both, in essence, a collective buying of securities as per a theme. They both invest in a mix of securities – stocks, bonds, or gold – as per the fund’s investment theme. Both can be bought or sold online with ease. Their returns are taxed similarly. But the similarities end there.

ETFs are often themed on market indices such as Nifty or Sensex. They are created to replicate indices and therefore provide returns similar to those indices. For example, an ETF based on the Nifty50 index will behave like that index, track its rise or fall, and provide nearly the same returns. This ETF will carry the same stocks in the same proportion as the Nifty50. Since the objective of such an ETF is to imitate the index, as a fund it requires no active management of its assets. Therefore its costs are much lower. Some of the largest index ETFs charge an expense ratio between 0.07% and 0.30%.

Conversely, an actively managed mutual fund will be created as per a theme — largecap, midcap, smallcap, flexcap, and so on — and its assets will be actively managed by a fund manager to increase gains and reduce losses. This fund will be benchmarked to an index but not obligated to mimic it. In fact, it aims to beat the index returns through the fund manager’s expertise in stock-picking. These funds have expense ratios normally upwards of 0.75%, going all the way up to 2.50% in many cases.

Why passive investing matters

Index investing was created and popularised by American investor Jack Bogle who founded the Vanguard Group and championed low-cost equity investments for the masses. Bogle reasoned that index funds allow investors to track the whole market at very low costs, as against actively managed funds whose charges eat into the returns. “Don’t look for the needle in the haystack,” he has famously said. “Buy the whole haystack”. What Bogle meant is that too many investors concern themselves with finding one winning stock when they may be served better by buying a whole market index made up of several high-performing stocks — which is what ETFs and index funds provide.

The idea of passive investing is taking hold in India. ETFs are not a new offering in India. However, 2020 provided an inflection point in ETF investing. As per figures provided by a large fund house, ETFs under management grew a whopping 61% between January and October 2020. This coincides with a period where many active funds are seen underperforming their benchmarks while still attracting the same charges. A Dow Jones analyst reported in March that in 2020, 80.65% large-cap active funds underperformed the S&P BSE 100 index, while 66.67% small and mid-cap funds underperformed the S&P BSE 400 index. This is a major cause for concern for active investors.

Where does active investing score?

An active fund aims to beat its benchmark through the fund manager’s expertise. Since it also requires much more buying and selling of securities, it entails higher costs than passive funds and ETFs. It’s not easy to pick winning stocks, and that’s where the deep analysis a fund manager can provide will be useful.

Last year, 20% large-cap funds beat the BSE 100, thereby providing the much-sought alpha — the returns over and above benchmark returns. This is why the costs of active investing may justify a preference for it, especially for investors who want to earn higher returns than an index. Even a difference of 1% above the benchmark returns could potentially lead to much higher compounded returns over time.

For example, let’s say you invest Rs. 1 lakh in a passive fund that will return 12% per annum on average, and another Rs. 1 lakh in an active fund that will return 13%. Both returns are inclusive of charges. Despite the slender difference in returns, the active investment would provide additional returns of 9.30% in 10 years, 19.46% in 20 years, and 30.56% in 30 years. At the end of 30 years, the active investment would be worth Rs 29.95 lakh while the active investment would be worth Rs 39.11 lakh. These are significant differences and could make a massive impact on the rate of your wealth creation. Conversely, if your active fund fails to create alpha, your losses could also compound at similar rates.

The choice for investors

Therefore, the choice for the small investor is clear. Does he want to settle for benchmark returns, or does he want to take higher risks to earn some life-altering alpha? Based on recent trends, we should see more small investors take to ETF and passive investing in certain categories such as large-cap equities where active funds are clearly lagging. In other segments where returns are better, investors may prefer active investing.

At the very least, index funds and ETFs provide investors with low risk appetites a gateway to investing in the securities market at lower costs and lower volatility compared to active funds. Expect higher adoption.