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What is the difference between a mutual fund and an ETF? Does compounding also happen in ETFs? Should small investors invest in ETFs? Can ETFs give good returns in 5-7 years? Please explain the prospects of Bharat 22 ETF.

Shyamsunder, Hyderabad

An exchange traded fund (ETF) is also a type of mutual fund. Like a mutual fund, an ETF also pools money from investors and channels it into a basket of stocks or securities.

Mutual fund schemes invest as per their mandate. For instance, they could be active funds that seek to deliver returns higher than their benchmarks. Or they could be passive funds that seek to move in tandem with their benchmarks. An ETF is a passive mutual fund with a mandate of mirroring an index and its performance. That is, the ETF holds the same basket of stocks in the same proportion as the index and its returns track the performance of the index. For instance, an ETF linked to the Nifty will have the same stocks and similar returns as the Nifty.

Lower expense ratios

Passive funds, such as ETFs and index funds, have much lower expense ratios compared with active funds.

That’s because unlike active funds that seek to outperform their benchmarks, passive funds only seek to keep step with their benchmarks; so, the portfolio management effort is much less.

In the passive fund category, ETFs have among the lowest expense ratios; this aids returns and reduces tracking error that measures how closely an ETF tracks its chosen index. An ETF unit represents a slice of the fund. Units are issued by the fund manager and then listed on exchanges for anyone to buy or sell at the quoted price.

An investor needs to have a demat account to be able to buy and sell ETF units; this means some additional cost on brokerage and account maintenance.

While earlier, ETFs were based largely on the market bellwether indices such as Sensex and Nifty, the category has expanded in recent years to track different indices and asset classes, with some ETFs also tracking custom-made indices.

Now, there are equity ETFs for different market-cap buckets, debt ETFs, commodity ETFs, overseas equity ETFs and thematic ETFs that track specific themes or sectors.

Compounding

Compounding in ETFs happens in the same way it happens in other mutual funds. The investment earns return for one period, the aggregate amount (investment plus first period’s return) earns return in the next period, this aggregate amount (original investment plus return of two periods) earns return in the next period, and so on. This continues until redemption of the investment at which point the original amount invested plus the cumulative returns over the periods accrues to the investor.

Whether you should invest in an active mutual fund or a passive one such as an ETF depends on many factors, including your return expectations and risk taking appetite.

A key question to answer is — do you seek returns that beat the benchmark with commensurate higher cost and risk, or are you ok with returns similar to the benchmark at relatively lower cost and risk?

Active or passive?

Of late, many active funds too have been having a hard time beating their benchmarks, thus showing passive investing strategies in a better light.

That said, there are several active funds that continue to deliver returns better than the benchmark. So, your choice between passive funds such as ETFs and active mutual funds needs to be well thought out.

Despite volatility in the short run, the equity market is expected to head higher in the long run and deliver inflation beating returns.

This holds true for mutual funds including ETFs too. This should help them make good annualised returns over 5-7 years.

The price of an ETF on the market is determined by the demand and supply for the ETF; so, liquidity on the exchanges is an important aspect to consider while selecting ETFs.

If you decide to buy ETFs, go only for those that have adequate liquidity on the exchanges; else, the market price at which you exit could be at a discount to the ETF’s net asset value (NAV).

In recent years, the government has also hit upon the ETF route to divest its holdings in PSU companies with the launch of CPSE ETF and Bharat 22 ETF.

While the CPSE ETF comprised largely PSU energy stocks, the Bharat 22 ETF that was launched late last year tracks the performance of 22 stocks across six sectors and includes some of the government’s holdings in a few private sector companies.

Besides public sector banks, miners, construction companies, and energy majors, the Bharat 22 ETF includes some of the government’s holdings in SUUTI (Specified Undertaking of Unit Trust of India) such as L&T, ITC and Axis Bank.

Other big names with a large weightage include SBI, Power Grid, NTPC and ONGC. Tail-enders include NALCO, Indian Oil, Coal India, Bharat Electronics, Bank of Baroda, NBCC (India), Indian Bank and SJVN. The ETF will be rebalanced annually.

The Bharat 22 ETF essentially comprises large-cap stocks, some good and others not-so-great. The performance of the weak stocks could be a drag on the overall performance of the ETF in the long run.

Send your queries to mf@thehindu.co.in

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