Investing would not be hard, if only there weren't multiple options thrown at the retail investor. When it comes to investing in the markets, there are 4 prominent investment vehicles that users often come across. Surprisingly, it is very difficult to find resources to help understand the difference between them. We write this post in order to explain the key characteristics and differences between them and hope our users have a better understanding about the right investment vehicle for them.
1. Mutual Funds
Hopefully, with our periodic weekly emails, you are already familiar with this category of investment vehicles. With Mutual Funds, several thousands of retail investors hand over their savings, starting as low as Rs.500, to a team of professional managers. The fund managers collectively manage a few thousand crores rupees which they invest in various stocks, bonds, commodities, etc. as per the mandate of the scheme with the help of their internal research as well as broker research reports. This process of decision making by the fund manager to select the stocks/bonds to invest in is called 'Active Management', as the team is actively researching opportunities for investment.
The gains from the investments are passed on to investors in the form of growth in value of NAV (Net asset value), or in the form of dividends. In lieu of the services rendered by the fund house, the investors are charged a fee, called expense ratio, which is usually 0.1-2.5% of the funds invested with them. This is an ongoing fee and is charged every year and is directly deduced in the form of reduced NAV of your units. Remember, this expense ratio covers not only the fund charges but also the distribution charges as is the case with Regular schemes. Read - DIRECT Mutual Funds - The ₹1 crore opportunity you need to know about!
2. Index Funds
These are just another category of Mutual Funds. The big difference? Instead of 'Active Management', these funds follow a 'Passive management' philosophy. Let me explain.
Are you familiar with Sensex and Nifty? These are market benchmarks constructed using a portfolio of 30 and 50 stocks respectively based on a set of rules (Trading volume, market capitalization, etc.). Just like Nifty and Sensex, there are several other benchmarks that are constructed and maintained by stock exchanges. In other words, these benchmarks are a portfolio of securities, held in a certain proportion as dictated by their pre-determined rules. For instance, Nifty 50 Index is constructed by taking the biggest 50 stocks in India and averaging them by their market capitalization(size).
While in 'Active Management', the fund managers research which stocks to buy and sell, in 'Passive management' they only replicate the portfolio of a certain benchmark. Since there are no efforts required for researching and active trading, the expense ratio of such schemes is quite low, which over a period of time leads to better returns because of cost savings.
But is the low cost itself good enough to deliver outperformance? Absolutely not! This category of funds originated from the proven research in western markets that over a long period active management of portfolio does not deliver better results than passive management. While this is true in the western markets, there is still no such proof in Indian markets, where active management still delivers a significant outperformance vs the benchmark. This outperformance is also called "Alpha". More on that in the chart below.
Exchange Traded Funds, or ETFs, are a recent phenomenon as compared to Mutual Funds. Yet, they are wildly popular in western countries, especially for commodities like Gold. ETF can be thought of as a type of Index Fund, with a twist.
In Index Funds, when you purchase or sell units, you transact with the Fund house, which later buys or sells the units from the open market in their respective allocation. The units are not actively traded. All transactions happen at the NAV of the day, which is published once at the end of the day.
ETFs, however, are actively traded on an exchange. Basically, an entity called as the sponsor of the ETF purchases the underlying portfolio of the Index and lists the units of ETFs on the stock exchange. When you purchase the ETFs, they are directly deposited in your demat account from the seller. Similarly, when you sell the ETF units, they are directly transferred to the demat account of the buyer. The underlying stocks of the Index are never traded. However, buying and selling units will attract transactions costs just like in the case of stocks.
In summary, ETFs are passively managed Index funds, actively traded on stock exchanges, which will have a lower cost as compared to Index funds but will attract transaction costs on buying and selling units along with the added cost of demat charges.
As with Index funds, ETFs closely follow the Index with a slight underperformance due to expense ratio. However, in India, these funds still lag the Actively managed large cap funds by a big distance.
As mentioned earlier, in highly transparent and highly liquid western markets, the ETFs and Index Funds, tend to outperform actively managed counterparts such as Large Cap funds over a longer period of time. However, the Indian markets are not as mature. There are still many opportunities for the Fund manager to identify value creating stocks and deliver significant outperformance with respect to the benchmark
We finally come to portfolio management services. This a category of investment vehicle that has caught the fancy of many investors in the last few months. Designed for HNI investors, PMS is quite similar to mutual funds in concept but varies wildly in working.
While the focus of a mutual fund is to follow a strict objective of the scheme and cater to the smallest investor, PMS focusses a lot on the stock picking skills of the fund manager and caters only to investors with usually a minimum of 25L rupees of investible assets. Usually, PMS takes a concentrated bet on selected stocks and are free to increase or decrease exposure to any limit in the investor portfolio. Many of these stocks are either mid cap or even small cap stocks as fund managers focus on identifying the next multi-bagger opportunity.
There are two kinds of PMS:
Discretionary, where the portfolio manager has the full control of the investment portfolio to buy and sell stocks on investor's behalf.
Non-discretionary, where the portfolio manager only recommends actions for the investment portfolio and it is the job of the investor to execute the same.
Unlike Mutual Funds whose NAV is declared every day, PMS is customized to every investor. There is no allocation of units as in the case of Mutual Funds. Hence the performance of these schemes is tracked using model portfolio created by the fund manager, which may or may not track the actual investment portfolio of the investor accurately. Even the cost structure of PMS is quite different. Usually, most of these PMS schemes charge an expense ratio such as 2%, with a profit sharing if the portfolio returns cross a certain hurdle rate, usually 8-12%.
In essence, PMS is an instrument for High Networth Individuals who have strong confidence in stock picking skills of the fund manager and don't mind the higher costs associated with it, as they expect the manager to return higher gains to more than cover up the costs of PMS.
Word of caution - Whenever you are suggested a particular product versus the other, it helps to question the interest of the adviser. The regulator has over the years capped the upfront and trail commissions of MF distributors. Hence, many of them are suggesting their clients to switch to PMS schemes, where no such caps exist. No advisor usually suggests Index Funds or ETFs since the commission earned from them are quite low as compared to Mutual Funds. While commissions themselves should not swing your decision, the buyer better beware of implications it may have on the quality of the advice they are receiving
At Expowealth, we only assist with transactions in Direct schemes of mutual funds and do not earn any commissions from any fund house for any recommendation.