Updated: May 24, 2022
This is an age old topic which is always up for a debate. When investing passively, retail investors (basically the common man investor) has the option to buy mutual fund schemes or buy units of ETF (Exchange Traded Funds).
But let me get this one thing straight, there isn't going to be one clear winner in this debate as to what is better- Mutual Funds or ETFs. They have their own merits and demerits. Let's explore a bit more then!
What is a Mutual Fund?
Mutual Funds are actively managed funds which have managers who manage what assets to buy and how much to buy/sell them. Mutual funds are authorized to hold their investments in stocks, bonds, other debt instruments (fixed income) etc. There are passively managed Mutual Funds as well which track indexes. Also, Mutual funds are classified into open and closed funds, which ideally mean that in an open fund, one can keep investing money throughout the year and also withdraw based on scheme policies while Closed Mutual funds do not allow investments at all times and you need to wait for subscription issues.
Regular v/s Direct Mutual Fund Investments: If you invest directly through the AMC (Asset Management Company, basically the company managing the fund), you pay less fees since they dont have to incur distribution charges while if you invest through a Mutual Fund distributor, you invest through the regular route which has higher charges. This affects your returns basically. Also there is something called TER (Total Expense Ratio) which would basically give you an idea as to how much your mutual fund expenses would be. If you have a high TER, you would be shelling out more money on expenses and making lesser returns on your capital.
You can invest in a Mutual fund through the Lumpsum route, wherein you pay the entire amount directly, or through SIP (Systematic Investment Plan), where you would invest some amount every month.
What is an ETF?
ETFs are Exchange Traded Funds which simply replicates various indexes. They are passively managed and just hold stocks or other asset classes in the same ratio that an index is constituted of. For example, if you buy NIFTYBEES (which is a very popular ETF in India), it would just be a replica of the NIFTY INDEX. It would move (up and down) in the same way the NIFTY would. Hence, if one invests in an ETF, they could expect returns based on the performance of the associated index. Since, ETFs are passively managed, they incur significantly less expense ratios.
So what are the parameters on which you should consider buying a mutual fund v/s an ETF?
1. Fees that you would pay :
While ETFs have an expense ratio of 0.1-0.7%, Mutual Funds charge anywhere between 1% to 2%. Both of these charges are taken annually. While ETFs dont have an exit load, Mutual Funds could have an exit load of around 1% if you withdraw within a year.
While ETFs can be bought or sold like trading shares at any point of time, Mutual Fund are bought/sold only after raising a request with the AMC. There could also be lock-ins connected to certain Mutual Funds
Mutual Funds generally have a higher tax liability compared to an ETF. But there are certain tax-saving Mutual Funds as well. They are very subjective. One has to read offer documents very carefully.
4. Returns: While ETFs generate returns which is completely correlated to the performance of the index, Mutual Funds are actively managed by fund managers who aim to beat the indexes.
5. Minimum Investment Criteria:
While some Mutual Funds do have minimum investment criteria to invest, ETFs are more flexible and one could even buy a single unit based on the price of the ETF. ETFs could be beneficial to people who wish to invest small initially and keep their investments liquid.
Do the Mutual Funds really beat the Indexes?
This will depend completely on the index we are talking about and also on the type of mutual fund. Ideally mutual funds should outperform the indexes since they are actively managed but it depends on the risk profile of mutual funds as well.
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Looking at the above figures which show historical returns of moderate risk mutual funds over a 1 yr, 3 yr and 5 yr horizon and Nifty50 annual returns over the years, it is pretty clear that indexes if played well (and with research) could give good short term results and also over a period of time (15-20 years, give you ~15% on an annualized basis).
Mutual funds also need careful selection i feel. If selected well, returns could be outsized (>20%) over a 5 year horizon which is much better than an index. But in the long run, an average mutual fund would find it very tough to beat the index.
Personal take: My take is, if you are someone who wants to play it safe, someone who is new to the markets and if you dont want to get into a lot of hassle of checking what is happening with your money, park your money in an index fund or ETF.
If you want to play more risky, do your own research and actively manage your money, choosing a bunch of mutual funds could be great. This could complement your investments in stocks and help you diversify your portfolio. Please do consult an advisor or do through research before putting your money into mutual funds. Some of them could be very risky or have high lock in periods.