Should you invest in Exchange Traded Funds (ETFs)
Exchange traded funds or ETFs as they are popularly known, are a special type of low-cost funds that invest in stocks of companies that are part of an index like the Sensex or Nifty 50.
The Sensex is short for sensitive index and comprises the top 30 stocks of all the companies listed on the Bombay Stock Exchange. Similarly, NIFTY comprises of the top 50 stocks listed on the national stock exchange. A Nifty ETF will invest in only those stocks, which are part of the Nifty 50.
Since the selection and weight is decided by the index itself, there is no active manager to manage your investments, hence management fees of ETFs are very low.
However, the returns are also directly linked to the stock market – If the market rises by 10%, the ETFs will rise by little less than 10% and if the markets fall by 20%, the ETFs will also fall by a similar percentage.
So, what’s the difference between an ETF and a mutual fund?
A mutual fund has a fund manager who actively manages the fund (i.e. buying and selling selected stocks based on their individual assumptions and the fund objective).
An ETF, on the other hand, is passive. It buys all the shares that comprise an Index. E.g. the Sensex or Nifty and does not require active management.
So when you buy a Sensex or Nifty ETF, you are actually buying small portions of the top stocks listed on these exchanges.
Since they don’t buy or sell stocks actively unlike the mutual funds, they are known as passive funds.
In developed countries, ETFs are very popular and are gradually even taking over mutual funds. In the years to come as the capital market in India matures, ETFs may turn out to be a better equity investment option.
ETFs are better options in comparison with mutual funds because of the expense ratio. If you were to invest in a large-cap mutual fund, the cost would range between 1.25%-2.50% p.a. However, if you select SBI Nifty ETF, the cost is 0.07%. Mutual funds may claim to beat the market but that claim is debatable.
Investing in an ETF and not worrying about the ‘best’ mutual fund is a good option for the first-time investor.