Passive investing: Wake up to the benefits of investing in ETFs

As returns from most categories of equity mutual funds have been disappointing, investors are increasingly looking at investing in exchange traded funds (ETFs). Low cost, transparent pricing, asset allocation needs and liquidity have led to a spurt in interest for ETFs. Asset management companies (AMC) are launching several new fund offers in ETFs for passive investing. The assets under management of 82 ETFs touched a record high of Rs 2.06 lakh crore in August.

An ETF is a basket of securities such as Nifty 50 index or BSE Sensex 30 index and is traded throughout the trading hours. As ETFs trade on bourses, an investor must have a demat account to buy and sell them. All ETFs mirror the benchmark they represent, the returns are in line with the benchmark they represent and the lower costs increase the net returns in the long term. As ETFs do not do active investment, the errors are just limited to tracking the index called tracking error, which is negligible.

Benefits of ETFs
Analysts say investors will prefer ETFs as many actively managed funds have failed to beat their benchmark returns. As ETFs are indexed-based, holdings are transparent because of the daily disclosure of portfolio. ETFs witness high volumes because they are traded on the stock exchanges. This helps in easy exit and liquidity and higher trading volume will make a particular ETF more liquid.

As the fund manager tracks the index stock and invests in the composition of the index, the operating cost becomes lower and investors have to pay a lower expense ratio. The expense ratio of an ETF is usually less than 0.5% as compared to 2-2.5% for an actively managed equity mutual fund. The trading value of an ETF will be based on the net asset value of the underlying stocks that an ETF represents.

Asset allocation
For investors, ETFs provide a good tool of asset allocation. Experts say investors can construct customised portfolios keeping in mind their financial goals, investment time and risk tolerance. If an investor invests in an index ETF for the long term, then the market volatility will not have much impact on the returns. By investing passively over a long period of time, an investor’s returns can be more than those from active stock picking. However, investors must also keep in mind that ETF investments cannot tap the high growth potential from some small and mid-cap stocks that may come up at times.

Unlike open-ended mutual funds, investors get the benefit of intraday movements in the market in ETFs. Investors must keep in mind that ETFs are like stocks. So, the investor will have to pay brokerage every time he makes a purchase.

Diverse products
There are equity, debt and gold ETFs. Retail investors are also moving to debt ETFs, especially the government’s debt ETF because of safety and better returns. And gold ETFs have reported stellar performance in the last one year. The Bharat Bond ETF is India’s first corporate debt ETF managed by Edelweiss Asset Management Company. It invests in AAA rated paper of state-owned companies and the ETF will hold the bonds till maturity. The credit risk in Bharat Bond ETFs is next to nil. These bonds are ideal for those in high income group because of tax-efficient returns. As it is a debt product, the long-term capital gains tax is at 20% post-indexation.

Gold ETFs from asset management companies are an ideal way to invest in the precious metal. Open-ended gold ETFs invest in physical gold and the returns are benchmarked on the real returns on investment in physical gold, subject to tracking errors. Investors are preferring to invest in gold ETFs because of the Covid-19 pandemic, slowing economy and rising inflation. Data from Association of Mutual Funds in India show that gold ETFs witnessed an inflow in August, for the fifth month in a row.