Why are ETFs Known as Passive Investment Vehicles?
There are two categories under which mutual funds can be classified based on the level of involvement of the fund manager:
Actively managed funds
Passively managed funds
Actively managed funds are those funds where the fund manager plays a key role in making investment decisions and is more involved with the everyday management of the funds. With passively managed funds however, the fund manager’s involvement is comparatively less.
Why are ETFs passively managed funds?
‘Exchange Traded Fund’/’ETF’ means a fund whose units are listed/traded on an exchange and can be bought/sold at prices, which may be close to the NAV of the Scheme. ETFs predominantly invest in stocks constituting an underlying index. They just trade like stocks so they are essentially index stocks that combine the benefits of a mutual fund with a listed stock. They are usually passively managed funds providing exposure to the performance of that index wherein subscription /redemption of units work on the concept of exchange with underlying securities. In other words, investors/institutions can purchase Units by depositing the underlying asset or equivalent cash amount with the Fund/AMC and can redeem by receiving the underlying asset or equivalent amount of cash in exchange of Units. Units can also be bought and sold directly on the exchange just like normal tradable listed securities.
Furthermore, as the ETF aims to match the returns of the benchmark and not outperform it, there is no need for the fund manager to actively make any changes to the fund even when market situations change. The investment decisions will be determined as per the underlying index. In case of any change in the index due to corporate actions or change in the constituents of the Underlying Index (as communicated by the Index Service Provider), relevant investment decisions will be determined considering the composition of the Underlying Index. The investment decision of the scheme will be carried out by the designated Fund Manager. Owing to the fund manager’s role in managing an ETF being relatively less, ETFs are classified as passively managed funds.
Benefits of ETFs as a passively managed investment vehicle
Low expense ratio One of the top most benefits of ETFs being passively managed investment vehicles is that they have a lower expense ratio than actively managed funds. The expense ratio of passively managed funds is typically under 1% of the annual returns. In the long term, this could make a significant difference to the investor’s earnings.
Easy to track Another benefit of ETFs being passively managed is that their stock profile remains relatively constant and therefore you can easily track it. ETFs are highly transparent, which allows you to know exactly what stocks your money is going into. For example, a Nifty 50 ETF will contain the exact 50 stocks that are in the National Stock Exchange (NSE) index. As an investor you can view this stock profile on the NSE website and then decide if you would like to invest in the corresponding ETF.
Tax efficient ETFs also provide some amount of tax efficiency because they are a passively managed investment vehicle. By simply matching the returns of the benchmark, they rarely result in large capital gains annually which in turn translate to lowered taxes. Furthermore, tracking error or the difference between the returns of the benchmark and the ETF also comes into play, which ensures that ETF returns don’t typically increase taxes by a significant margin.
Risk of passive investment As these funds are passively managed scheme, they may be affected by a general decline in the Indian markets relating to its Underlying Index. The funds will invest in the securities included in its Underlying Index regardless of their investment merit.
Why investors might consider investing in passively managed investment vehicles?
Apart from the benefits mentioned above, passively managed investment options like ETFs, could serve an important purpose in an investment portfolio. One of the main objectives of creating an investment portfolio is to diversify the investment and spread the risk over various asset classes. This helps to dilute the risk to some extent and could also lead to an increase in returns over time.
However, adding multiple schemes to a portfolio could turn out to be an expensive exercise. Choosing to invest in ETFs could help diversify your portfolio without increasing the overall expenses by a lot. As there are various types of ETFs like equity ETFs, debt ETFs, commodity ETFs and bank ETFs; you could choose more than one type and receive the benefit of diversification with just a slight increase in expense ratio.
You also get the freedom to trade ETFs on the stock exchange in real time without the involvement of a fund manager. This gives you the chance to make the most of increased selling prices of ETF units as and when they see an opportunity to do so. You will also have the option to buy and sell ETFs on your own also save time as you don’t have to put in a request with a fund house and wait for it to be processed before the redemption amount can be credited to your account.
ETFs are one of the fastest growing investment options in India today. These passively managed funds give you a convenient and low-cost avenue into equity investing without having to be highly experienced in how stock markets work. With newer ETF products being introduced into the markets at regular intervals, you get a chance to explore from a wider range to enhance your portfolios.
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Visit www.icicipruamc.com/note to know more about the process to complete a one-time Know Your Customer (KYC) requirement to invest in Mutual Funds. Investors should only deal with registered Mutual Funds, details of which can be verified on the SEBI website https://www.sebi.gov.in/intermediaries.html For any queries, complaints & grievance redressal, investors may reach out to the AMCs and / or Investor Relations Officers. Additionally, investors may also lodge complaints on https://scores.gov.in if they are unsatisfied with the resolutions given by AMCs. SCORES portal facilitates you to lodge your complaint online with SEBI and subsequently view its status.
Mutual fund investments are subject to market risks, read all scheme related documents carefully.