Difference Between Exchange Traded Funds and Active Equity Funds
Exchange traded fund or ETFs are passive schemes which track market indices e.g. Nifty, Sensex, Bank Nifty etc. Exchange traded funds invest in a basket of securities that replicate the constituents of the index which the ETF is tracking.
Exchange traded funds are listed on stock exchanges and are traded like stocks. You need to have Demat and trading accounts to invest in ETFs. Though actively managed equity funds remain very popular in India, exchange traded funds are rapidly growing in popularity. As per AMFI data (as on 29th July 2022), exchange traded funds constitute the largest mutual fund category in terms of assets under management (AUM). In this article, we will discuss the difference between ETFs and actively managed equity funds
Differences between ETF and active managed equity funds
- All actively managed equity funds have a benchmark index (refer to the scheme information document to know the benchmark index of your active equity fund). The benchmark index has the same risk profile as the fund. For example, the benchmark index of a large cap fund may be Nifty 100 TRI while that of a midcap fund may be Nifty Midcap 150 TRI etc. The fund manager of an active equity fund aims to beat the benchmark index. The difference between the fund returns and benchmark returns is known as alpha. Fund managers of active equity funds aim to create positive alphas. Higher the alphas, better is the performance of the fund manager.
- Unlike actively managed equity funds, exchange traded funds do not aim to beat the index; the simply aim to track the index. In other words, you will expect the index returns (e.g. Nifty 50 TRI returns) by investing in the index ETF (e.g. Nifty 50 ETF) subject to tracking errors.
- Since actively managed equity funds aim to beat the index, they have to invest differently than the index. In order to the beat the benchmark index, the active equity fund will have to overweight or underweight on some stocks or sectors relative to index. This gives rise to additional risk, over and above market risk. This additional risk is known as unsystematic risk.
- Since exchange traded funds do not aim to beat the index, the underlying portfolio of an active equity fund and that of its benchmark index is exactly the same. So there is no unsystematic risk in exchange traded funds. Exchange traded funds are only subject to market risk, which active funds are subject to both market and unsystematic risk.
- Since actively managed equity funds aim to beat the index, it requires considerably more fund management effort. Active funds also have to be supported by a strong research team. Exchange traded funds on the other hand do not require much fund management or research effort because they invest in the same basked of securities as the benchmark index. As a result the Total Expense Ratio (TER) or cost of active funds is much higher than cost of ETFs. The TER of a fund gets adjusted in the fund Net Asset Value (NAV) and therefore impacts the returns.
Conclusion
In this article we have discussed the differences between exchange trader fund and active equity funds. ETFs have lower costs and risks compared to active funds. On the other hand, active equity funds have the potential of generating superior returns over long investment tenures. You should discuss with your financial advisor if ETFs or active equity funds are suitable for your investment needs.