The Family of Index Fund, ETF and Mutual Fund

Dealing your cards the right way is immensely challenging when you’re a newbie in the corporate world. Actually, scratch that. It can be challenging even if you’ve had oodles of experience. But that’s not to say that experience doesn’t help. It most definitely can go a long way. How valuable it is for you (or at least your stocks) to be at the right place at the right time is essentially unparalleled.

Breaking it down to the lowest level

What are Index Fund, ETF and Mutual Fund, and what is the relation amongst them? The easiest way to think of it, is to imagine a funnel, with a large mouth and relatively tiny nozzle.

You have your mutual funds, the assembly of which forms the superset. Mutual funds are generally managed by large finance companies in place of finance investors who don’t have the time or skill to invest, who in turn pay a fee for the nitpicking of relevant stocks to add to their collection of securities. This is called active management.

A small segment of mutual funds comprises index funds, the subset of the former. The index fund simply buys all the stocks that make up an index. This kind of management is called passive management and rightfully so. Here, the funds aren’t specifically chosen by an analyst. This could almost be compared to buying lottery tickets in bulk, most of them give average returns, but there is still scope for way more. Since there isn’t much intellectual property being exhausted (relatively) to form considerations and comparisons, the fee that goes to the company is a lot smaller than in the case of active management. On the other hand, these funds will always perform worse than index itself.

Further in the funnel is the collection of ETFs, or exchange-traded funds. These are closed ended mutual funds that are traded off like stocks. For example – gold ETFs, Nifty ETF. ETFs can be exchanged multiple times a day, which proves to be quite useful in the day in the life of an active investor. ETFs are also not sold directly by a fund company, rather they are listed on an exchange. Again, there is a fee to be paid to own and use a brokerage account which is required in this case.

Who wants anything but the best?

Now that we have a general idea of how things happen, let’s cut to the chase. You want to know what’s best, of course. Now the word ‘best’ in its truest sense is pretty vague. What you should be asking is what’s best-suited for you. There’s a flood of factors that directly determine how a stock or a holding values itself in the market. Hierarchizing these factors in respect of your personal preference before investing is the something you’ll definitely thank yourself for.

Passive Vs Active Funds

Passive investors love ETFs and Index Funds because of how easy they are to understand. Highly flexible, they require neither remarkably special documentation nor margins to be managed. Moreover, they come in bite-sized holdings which offer a relevant range for small investors. They are plenty convenient, mainly due to the fact that they can be traded as easily as stocks. But the convenience comes at a cost. Index funds can never outperform the index because of the costs and index-tracking aspect. Similarly ETFs, due to the lack of active management, cannot take advantage of the volatility and other economic factors.  Some people believe that ETF or Index funds provide mediocre returns because of the factor of no concentrated effort but they are still a far better bet than active management.

Surprisingly, in India, the difference between a well managed mutual fund and a benchmark index fund or ETF has been 3-5% in past 15-20 years. Research shows that over the years, active funds have delivered very good returns, even after the higher expense ratio being paid for. Therefore, most of the investors looking for good returns prefers Mutual Funds. The activity of stock picking, rebalancing and keeping track of the macro and micro economic coming at a cost of 1-3% is a sweet deal for everyone.

Getting Personal

Now that all the cards are laid out on the table, it’s time to decide what’s best-suited for you. Whether to invest in Index Fund, ETF or Mutual Fund, It’s all really a matter of what precedes what in your own personal pecking order. Most importantly, it’s necessary to keep your short-term and long-term future/goals in mind while making the big decision. Once that’s in place, you’re good to go. Happy investing!