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Generally, this happens when various indices manage to do better then investors and mutual funds, or when different parts of the market move at decidedly different pace.
Not only are we in such a situation at present, such cases have occurred more regularly of late. Such funds are called passive funds, because they don’t require investment management in the normal sense. There isn’t a fund manager, who is responsible for deciding where to invest. Instead, the fund is a mirror of a market index, such as the Sensex or the Nifty or any other index.
Exchange-traded funds (ETFs) are a special case of index funds. They are mutual funds, but are bought and sold like shares.
When you want to buy or sell one, you go not to a mutual fund salesman but to a stock broker.
This route of buying a fund means you need a demat account, but if you already have one, it’s probably more convenient than the normal route for buying a fund.
Unlike a normal mutual fund, in which you buy and sell units from the fund company itself, ETF units are traded on the stock market between investors.
However, the fund company arranges to absorb any excess supply of units that an investor would like to sell or create fresh units when the demand for units is large enough. As a result, the trading price of an ETF is not supposed to be heavily impacted by demand-supply imbalances unlike normal shares.
ETFs are inherently very low-cost funds. While an actively managed mutual fund often deducts expenses up to 2.25 per cent, the cost on ETFs is generally in the range of 0.3 per cent to 1 per cent. With compounding, this can build up to a significant difference over time.
Exchange-traded funds are supposed to be good for those who just want to ‘buy the market’, that is, buy an index fund. Besides being low cost, their quick and guaranteed liquidity make them attractive to many investors.
The fact that they can be bought or sold throughout the day at the available price makes it a better way for trading in the broader market than a normal index fund, which is available only at day-end NAV.
However, regardless of what the theory of ETFs says, Indian ETFs have been exhibiting some decidedly non-ETF like behaviour. ETFs are not very popular in India yet, and their low volume means the quoted price of some ETFs often meanders away from a tight correlation of the underlying index. Still, over a long period, ETFs always give returns that are near identical to the index.
Curiously, many investors have only heard of ETFs in the context of gold ETFs. Whenever the price of gold zooms up, there is renewed interest in gold-based funds, but these are all ETFs.
Investors who don’t have a demat account and a regular stock broker often face trouble buying these funds. To make it easier for investors to invest in gold ETFs, fund houses are trying to launch normal mutual funds that invest in gold ETFs.
I’m not sure whether ETFs will ever become popular in India. Their low cost should make them the choice by default as passive investing becomes more popular. However, the low volumes and divergence from underlying indices could result in a chicken-and-egg situation, which could hold back ETFs from playing a larger role.
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