Equity ETFs vs Diversified Equity Mutual Fund

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The importance of being active couldn't have been explained better. To put it simply, one needs to be active in his or her daily life, if one desires to succeed. An active mind always helps in making sound decisions which otherwise (if you are not active) could lead to chaotic situations (one does not make the right decision).

On the other hand if you remain passive (i.e. not active) in whatever you do, you will surely see yourself at the losing end.

 

Now, that you are aware of how important it is to be active, make sure that your investments are active in generating long term growth in order to make you wealthy as well as healthy.

 

While investing in mutual funds too, you investors need to be careful while selecting the right mutual funds according to your ability to bear risks. You need to keep in mind that while there are mutual fund schemes which are actively managed in order to outperform their respective benchmarks and provide a phillip to your returns, there are some passively managed funds too, with an aim to mimic or imitate their benchmarks in terms of returns and composition.

 

Let us probe further into this.

 

Actively managed mutual funds

 

Actively managed mutual funds or diversified equity schemes as we call them are always on a constant look out for opportunities across various market segments in order to generate superior returns with sole intention to beat their selected benchmark indices. The fund managers actively participate in managing these funds in order to provide superior returns; while at the same time intend to minimize the associated risks.

 

Advantages:

 

·         Superior returns

·         Diversification across various sectors and market capitalizations

·         Flexibility and liberty to change investment style and strategy to minimize risk or boost funds performance

 

Disadvantages:

 

·         Medium to high to very high risk profile

·         High transaction cost and expenses

 

Passively managed funds

 

On the other hand passively managed funds or Index Funds or Index Exchange Traded Funds (ETFs) imitate their respective benchmarks in terms of composition and returns. Their sole objective is to mirror the performance of their respective benchmark indices. Over here the fund managers are not as active as they are in managing diversified equity funds, but let the fund perform in line with the respective index.

 

Advantages:

 

·         Low transaction cost and expenses

·         Market related risks

·         No need to actively track the performance

 

Disadvantages:

 

·         No flexibility to change investment style and strategy to minimize risk or boost funds performance

·         Limited investment universe

·         Less diversification across market capitalizations

 

Wait a sec! Why are we here talking about active and passive funds, when our intention was to enlighten you about Diversified Equity Funds and Equity Exchange Traded Funds

 

Well, Diversified Equity Funds are actively managed funds and Equity ETFs are mostly passively managed funds but some fund managers are trying to make these ETFs actively managed by using re-allocation strategy but holding stocks from the selected Index itself.

 

As Equity ETFs despite being passively managed are soon catching the eyes of the investors with some recent innovative launches and ease to trade, so here we are going to talk about Equity ETFs and nothing about Index funds which continue to hold their old passive management style.

 

Now, that you are already aware of the advantages and disadvantages of both active and passive funds, let us first look at some of their performances in order to have a clear idea.

 

Mutual Fund Report Card

From the table above it is evident that diversified equity funds have given luring returns mainly over 3-Yr and 5-Yr periods. Moreover, the risk adjusted returns too have been enticing for most of the diversified equity funds.

 

However, over the past 3-Yr and 5-Yr period and also over the past 1-Yr period some equity ETFs basically focusing on banking sector have managed to outperform the diversified equity funds, but a point to note is that this out performance has come with high volatility (as can be made out from their high standard deviation of over 12%). But index based equity ETFs have broadly underperformed the actively managed diversified equity funds and have not able to deliver sufficient risk adjusted returns (as can be seen from their low Sharpe Ratio).

 

The largest equity ETF (Nifty BeES) seen treading on low path along with its

From the above graph, if one were to invest a sum of 10,000 in Nifty BeES and HDFC Top 200 Fund for a period of say 5 years, the investment would be worth 17,696 and 22,564 in Nifty BeES and HDFC Top 200 fund respectively.

 

Should one trade in equity ETFs?

 

Also a point to note here is that equity ETFs are mutual funds and not stocks. There have been many cases where people try to take very short term market calls and get involved in short term trading of equity / index ETFs (as they are easily tradeable).

 

But before doing this, they do forget that high trading may unnecessarily increase the cost and also lead them to loose out on net returns. Also trading on short term market calls attracts short term capital gains tax leading to low post tax returns from equity mutual funds.

This high trading strategy in equity ETFs is definitely of no use for one who is aiming for wealth creation from equity mutual funds.

To sum it up, a diversified equity fund with a proven track record of atleast 3 years and from a fund house having prudent investment systems and processes in place is able to broadly outperform equity ETFs and that to with lower or similar volatility but better risk adjusted returns.

However, before taking any investment decision, you as an investor need to evaluate your risk appetite, investment goals etc. Though an equity diversified fund is bound to outperform equity ETF due to its diversification across different sectors and market capitalisation and the fund manager's liberty to change his strategy based on his view on the market; You should adopt a prudent and systematic approach towards selecting and investing in the right diversified equity mutual funds (as not all diversified equity funds are well managed and able to provide superior returns).

An investment in equity ETFs can however be considered only if one has no access to unbiased investment advice or is naïve to mutual fund investing and is looking for only market related risk and returns.

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Some of the Top performing Mutual Funds are

1. HDFC Top 200 Fund
2. ICICI Prudential Dynamic Plan
3. DSP BlackRock Top 100 Fund
4. Birla Sun Life Front Line Equity Fund
5. Reliance Equity Opportunities Fund
6. IDFC Premier Equity Fund
7. SBI Magnum Contra Fund
8. Sundaram Select Midcap
9. UTI Dividend Yield Fund