The popularity of ETFs has been rapidly growing across the world, especially in the developed markets. In India, ETFs still comprise a very small portion of retail and HNI assets under management (AUM). But investor interest in ETFs has been growing over the past few years. There are several reasons why to invest in ETFs.

• Low costs: Since ETFs are passively managed funds the Total Expense Ratios (TER) of ETFs are much lower than actively managed mutual funds. For the same performance of the underlying portfolio a 1.5 – 2% difference in TERs can result in a substantial difference in absolute returns over long investment horizons, due to the effect of compounding. Cost is one of the main reasons Why ETFs are good.
• Generating alpha will be more difficult for certain funds: As a market matures, it also becomes more efficient. In highly efficient markets, it is difficult for fund managers to create alphas (excess returns over market). Evidence from developed markets confirms that alpha creation is becoming increasingly more difficult. There is some evidence of this in India as well and as our market matures further, alpha creation will also get increasingly more difficult for certain funds. If an actively managed fund is not able to create sufficiently high alphas to cover the higher TERs, then they are likely to underperform versus ETFs that invest in the market segment. This is one of the reasons why are ETFs better than mutual funds.
• No unsystematic risks: In order to create alphas, fund managers of actively managed schemes have to overweight or underweight on certain stocks relative to the index. The relative overweight or underweight positions may or may not always result in higher returns; sometimes it may result in lower returns than the market. This is known as unsystematic risk. Actively managed funds have both market risk and some amount of unsystematic risk even though they diversify across stocks and sectors. There is no unsystematic risk in ETFs because you are invested in the same basket of stocks as the index, in exactly the same positions. ETFs are only exposed to market risk. This is the reason why invest in ETFs over stocks.
• Underperforming stocks have lower weights in index: In market capitalization weighted index, a stocks weight in the index will be lower if the stock underperforms. An ETF which tracks the index similarly will have lower weights for underperformers in their portfolio.
• Simpler to invest: In actively managed mutual funds, there can be a large variation in performance of top quartile and bottom quartile schemes. You need to look at the long term track record of a fund manager and select a scheme which has consistently created alphas. Even if you select a top performing scheme, there is no guarantee that it will continue to outperform in the future. You will have to monitor the performance of the scheme on a regular basis. It is much simpler to invest in ETFs. Since ETFs track different market indices, you simply need to decide which index to invest. Then you should select an ETF which has low expenses since an ETF with low expense will always outperform an ETF with higher expense.
• Gold ETFs: Investing in Gold ETFs is a much more efficient way of investing in Gold compared to buying physical gold in form of jewelleries or gold bars / coins. Physical gold (especially in form of jewellery) has impurities and also involves storage costs. There is also the risk of theft, unless your physical gold is in a secure storage e.g. bank’s locker. There is no risk of impurities and theft for gold ETFs. Storage costs are also much lower because your ETF will be in your demat account along with your shares and bonds.