Whenever someone asks me, why I prefer Exchange Traded Funds (ETFs) or Index Funds for my investment, my answer is – Its Simple, process driven and low cost.
Simple: ETFs and Index Funds based on broad market indices are very simple products to understand. There are over 400 equity mutual fund schemes. Further categorized as large cap, mid cap, small cap, sectoral, thematic etc. Index trackers like ETFs and Index Funds provide plain, simple, and easy to understand investment solution.
Process driven: The methodology governing the rules of index construction and maintenance are in public domain and are rarely changed. ETFs and Index Funds must mandatorily and diligently replicate the underlying index. They do not have any freedom to deviate from underlying index. On the other hand, in active funds significant discretion is vested in the strategy and fund manager. For e.g., a Large Cap oriented scheme have the discretion to invest in Mid or Small cap stocks up to 20%. However, a Large Cap oriented ETF or Index Fund; like Nifty 50 Index or S&P BSE Sensex Index schemes do not have such freedom – either in stock allocation or asset allocation. Hence investors of such index schemes do not require to closely monitor intricacies of the portfolio like in the case of an active fund. Further the investor in an index fund or ETF does not have to track issues such as changes in underlying fund management philosophy, fund manager etc.
Low Cost: ETFs and Index Funds are generally less costly as compared to actively managed funds. This is primarily because, these schemes are not required to allocate any resources towards research etc. Generally, trade execution brokerages paid by ETF and Index Fund schemes are also lesser than its active counter parts. This saves overall cost and thus may help in enhancing returns for investors.
Thus, ETFs and Index Funds provide simple and process driven investment options at reasonably low cost.
This does not mean that all index funds or ETFs are identical in terms of performance. The key objective of such funds is to replicate or track the performance of underlying index as closely as possible. Any deviation in such tracking is commonly known as ‘Tracking Error’. This measures how closely the scheme is tracking the underlying index. Lower tracking error suggests lesser deviation in replication of underlying index. Lower tracking error reflects efficiency of managing the scheme.
While selecting ETFs or Index Funds, generally investors only consider its stated cost i.e., Total Expense Ratio (TER) ignoring other critical aspects. While analyzing these schemes, investors should consider size and tracking error along with its TER.
Let us understand this with an example
As mentioned above, there are four funds. In this case, most of the investors will choose “Fund C”, as its annual TER i.e., cost is the lowest. But what about other aspects like its size of asset under management and tracking error.
We can rank these funds based on their respective TER, AUM and Tracking Error and simply sum up the ‘ranking number’. The fund having lowest sum of ranking numbers may be the prudent option e.g., Fund A in this example.
Even though it is having highest cost of 0.20% annual TER, but when its size i.e., AUM of Rs. 3,000 Crs and its performance i.e., tracking error of 0.12% is also considered it may provide better choice over other options.
In evaluating what is the best product for you it is prudent to consider critical aspects like size and tracking error along with stated cost before judging the scheme. Further Investors may add their own selection parameters like e.g., ease of operations, cost of holding etc.
ETFs and Index Fund are low-cost investment option and cost is one of the critical aspects. However, investors should consider other aspects also, instead of just the stated cost (TER) of the scheme.
An Investor Education Initiative by UTI Mutual Fund
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