Which one to choose, ETFs, Index funds or Mutual funds?

Mutual funds (MF) are institutions, pool money from investors to invest in the stock market. It is an indirect way of investing in the market by retail investors to fetch returns where the personal selection doesn’t fill their pockets. Every fund is run by a manager who professionally manages investor’s money to produce average returns. Why are we smashed with a huge number of funds which offer the same service with indistinguishable returns?

Mutual funds compel you to pay whatever the cost it incurred to produce returns which are not stable most of the time. The organization revises the expense according to its need of money from the returns produced. Mutual funds should be paid the fixed amount with or without delivering outstanding returns. Statistics say 80% of the mutual funds fail to beat the index and the rest produce a little above the index where the 2% of the funds managed to produce extraordinary single year performance. When the observed time of the data is increased many funds cease to produce beating gains which is a direct indication of inconsistency in achievement.

Since the mutual fund industry is not fully regulated innumerable amount of banks and financial institutions prey on this to capture business. New fund offering (NFO) is a way of increasing the size of the fund which directly affects the performance of the fund. In every business, market share captured or the size of the fund is the prominent parameter which decides the industry’s commander. No company is working to make the investors rich.

Large cap funds or blue chips are highly inflated because of immense liquidity by mutual funds who all stay invested and make them less the top less volatile. SEBI has compelled all the flexi cap funds to allocate funds on all kind of stocks inorder to stay true for the name. Even after so much made to distribute funds among all kind, the liquidity going into small caps are still less.

Larger the fund size more is the income as expense. The expense ratios are inversely proportional to the fund size but the industry alters it according to their financial needs. The expenses would be more on a well established fund and for funds to pick up they are quoted less even though the AMC’s income can manage to run the fund.

Habitually, mutual funds are run by a bunch of MBAs, CAs, CFAs, who all are being paid a high salary. As many investors think mutual funds never function like we read in books. Every fund allocates 1% in cash for unforeseeable withdrawals which acutely affects the net performance, they are never invested. After a certain period of time the fund gains momentum and cash starts to pour in, managers cannot wait for the market to slip from the position of efficiency to bootless. The cash is pumped into the market, ensuring enormous liquidity for meager gains from the present inflated value. This makes the industry fruitless. From Ben Graham to newbies all have been taught to buy below the intrinsic value, the bargains are available only when the market becomes inefficient which is wonderfully quoted as,

The markets can remain irrational longer than you can remain solvent.

John Maynard Keynes

As far as the fund size is considered, low to medium size funds can operate comfortably to produce extraordinary returns. Rooms for index beating results are very scarcely available because of market efficiency and the more than 40 AMCs, more than 1500 funds stay fishing with huge cash in hands. MFs run ads, MF distributors work for them, magazine tie-ups all resulted in more cash infusion, all this being done where will they fit in to fetch you returns. AMFI drafted rules to run a fund, which specifies, not more than 10% goes into a particular stock, if the manager plans to buy the smaller ones the holdings should not be more than 5% of the business.

Mid cap stocks are the most helpful because of frenetic development and rapid implementation of business strategies, ergo Emerging Markets.

Can small cap stocks be helpful?

Since small cap stocks are highly volatile and produce huge returns comparatively a huge size of the portfolio cannot constitute the small players. As already said Beta is just a representation of the swing, the fund managers avoid the small cap stocks which show high mobility in tough times that drastically affect the portfolio’s performance. A research team spends the same amount of time and effort to pick a small one, which in most cases is a waste of time because of the regulations, allowing them only a small part to be invested yielding insignificantly. Small cap stocks are mini series, which lacks reliable historical data, a serious issue.

What happens when a fund outperforms?

Once the performance is reached, everyone sits tight. No, every square of the newspaper will be filled with enormous data of the fund and the manager. People rush to invest that’s the day, every other professional knows the next year will be tougher to keep up with any index. You may think of jumping in before the out performance by learning the manager. Don’t even try to, it’s as much as tough as predicting heads with thousands of sides. Business has numbers, the qualitative nature of a human is hard to find.

Apart from managing your money, MFs are said to diversify the profile, the point is all kinds of fund pooling ETFs, Index funds, etc., all does the same. MFs are no special other than the hugeness. The point is who reduce risk to maximize gains, either one is sufficient to stand out.

After a so long discussion about mutual funds, taxation, book cooking, High hidden expenses all gets adds weight to the negative side. ETFs and index funds are best alternatives to actively managed mutual funds.

The Sharpe ratio is one useful parameter which measures risk to return meaner than any variable. It’s the ratio between expected return for the incurred risk if this world accepts volatility as the demon. Slope of the above graph is the graphical representation of the Sharpe ratio.

ETFs are funds same as mutual funds which are traded in the market.

  • Low cost alternative- Brokerages and infinitesimal AMC charges.
  • Flexibility of trading in and out of the fund.
  • Tax friendly investing
  • No investment minimum- Trading with the amount of NAV is possible.
  • ETFs are even considered as an evolution of the financial world. Bridge water associated have ETFs in their portfolio.

They still have their contribution to the negatives, but they are more into unsystematic risk like ETF bubble, some are overly concentrated, some are expensive. Since an Exchange Traded Fund tracks an Index, it does not rely on active investment calls provided by a fund manager. Hence it is not affected by the errors that a fund manager might make. It can sometimes have an error in tracking the index (called tracking error), but this is usually small in magnitude and therefore, can be ignored.

On the other hand index funds play within the index, which are passively managed to beat the index itself.

If you know nothing and to participate in the market’s foray, an index fund is a worthy bet. If you know something about how the capital market works, ETFs and MFs can help you. Most of the hedge funds go with ETF investment, including Bridgewater Associates, the largest hedge fund. Whatever the type of fund is, passively managing them has the advantage of less expenses, but the opportunity cost of missing market inefficiencies is huge. The infrequent, large bets once in a year would be sufficient to attain market beating returns.

Value investing is preached all over the world, but the lion’s share of them fails to run it that way. Patient opportunism will bring them what they want for the whole years of ambush.

Most widely traded ETFs are:

ETFTracking Index3Yr return5Yr return
Nippon India ETF Nifty BeEsNifty 5014.468.14
Motilal Oswal Nasdaq 100 etfNasdaq 10021.59
Nippon India ETF Liquid BeES—–4.95.45
HDFC Gold etfGold17.6212.32
Principal Nifty 100 Equal Weight FundMid Cap7.5811.8
Equal weight funds performed better than wide chosen ETFs

The choice of yours boils down to, “put some work”. Investing your money should have a meaningful return and to overcome the risk of underperforming fixed income securities.

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