Advantages and Disadvantages of ETFs

Tushar Mathur — Sun, 24 Aug 2008 15:03:17 +0000

This is the 2nd installment of our 2 part series on ETFs. Please read the first part here: Investing in ETFs

Advantages of ETFs

1. ETFs tend to be more cost-effective vis-a-vis comparable mutual funds. For instance, while the expense ratio of a passively managed ETF (tracking a benchmark index) would normally be in the range of 0.50%-1.00%; for an index fund, it can be as high as 1.50%.

2. Another important advantage with ETFs is that they provide more flexibility to investors than regular mutual funds. Since they are traded on the stock exchange, they are available to investors any time during the trading hours. So investors can buy and sell units of an ETF on a real time basis, unlike regular mutual funds, which can be transacted only at end-of-day NAV.

3. Since ETFs witness most of the buying/selling on the exchange, the interests of the long-term investor are not compromised. Take a regular equity fund where units are bought and sold at the AMC’s end – when a significant amount of money enters and exits the fund rather quickly, the long-term investor could suffer as a result of the costs (trading costs, registrar costs and opportunity loss, if the fund manager is forced to sell his best stocks) associated with this quick inflow/outflow.

With an ETF, since the trading investor does not approach the AMC at all and only interacts with other investors over the exchange, his quick entry/exit does not compromise the interests of the long-term investor.

4. Given ETFs are traded on the stock exchange, and can be bought/sold on a real time basis; they tend to have low tracking error (deviation of ETF’s performance from that of the underlying index) as compared to index funds.

Disadvantages of ETF

1. Investors need to have a demat and a trading account, with a SEBI registered stockbroker, for investing in ETFs. For investors, who do not trade in stocks, this could be a bit of a deterrent. Also, maintaining a demat account entails paying annual fees (approximately Rs 500), however the same varies across stockbrokers. For investors, who invest in stocks, this will not pinch as the maintenance charge of the demat account will be spread across the stock and ETF investments.

2. While investors have to incur entry/exit loads at the time of making/redeeming investments in mutual funds, for ETFs they have to pay a brokerage (usually around 0.50%) to the stockbroker, along with other applicable charges (STT for instance), every time ETF units are bought or sold. For a trader who frequently trades, this can have a significant impact on the net returns. But for long-term investors, these expenses hold little relevance.

What investors must do
It is evident that ETFs offer a different investment proposition vis-à-vis conventional mutual funds. ETFs may appeal to investors who want to track the performance of a particular benchmark index (such as S&P CNX Nifty or BSE Sensex); Similarly, the ETF route can also appeal to investors who are desirous of investing in asset classes such as commodities (e.g., gold), or even REITs (e.g., international real estate and homes). The allure of ETFs will only grow given the expanding bouquet of offerings.

Investors on their part would do well to thoroughly understand the pros and cons of ETFs; this will help them make informed investment decisions. Also, investors must consult their investment advisors/financial planners to determine the suitability of an ETF in their investment portfolios.

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Should I invest in Gold ?

Tushar Mathur — Mon, 25 Feb 2008 06:54:56 +0000

Looking to invest in Gold funds but don’t know too much about them? Here are some basic facts to get you started.

What are Gold funds?

Gold funds are similar to mutual funds except that they invest in gold instead of debt instruments or equity shares. A unit of a Gold fund is nearly equivalent to a gram of physical gold.

How does it work?

A Gold fund collects money from investors and uses it to buy gold in physical form. Of the total money collected, a major portion is used to buy gold and the rest is invested in low-risk debt products such as bonds and money market instruments. It does not invest in equities. As the major portion of funds is invested in gold, the performance of the fund depends on the price movement of gold. The performance of the fund is reflected in its Net Asset Value (NAV). This gives you a chance to make fresh investments even after the initial offer closes.

Is it suitable for all?

Till date investment in gold has always been through jewelry or coins. But there is a physical limitation to the actual amount of gold you can store. Besides, you cannot take advantage of the price variation in gold. But with Gold funds, you do not have these problems. All that you have to do is buy units in a Gold fund and these units will be credited to your demat account. It is advisable to allocate 5-10% of your savings towards investing in gold, as it has been shown that after equity and property, investment in gold yields the most returns – around 7-8% over the long term.

Reasons to say YES to Gold

* The dollar is weak and getting weaker due to national economic policies which don’t appear to have an end.
* Gold price appreciation makes up for lost interest, especially in a bull market.
* The last four years are the beginning of a major bull move similar to the 70′s when gold moved from $38 to over $800.
* Central banks in several countries have stated their intent to increase their gold holdings instead of selling.
* All gold funds are in a long term uptrend with bullion, most recently setting new all-time highs.
* The trend of commodity prices to increase is relative to gold price increases.
* Worldwide gold production is not matching consumption. The price will go up with demand.
* Most gold consumption is done in India and China and their demand is increasing with their increase in national wealth.
* Several gold funds reached all-time highs in 2007 and are still trending upward.
* The short position held by hedged gold funds is being methodically reduced.
* U.S. government economic policies over the past decade have systematically projected the U.S. economy down a road with uncontrollable federal spending and an uncontrollably increasing trade deficits. Both will cause the dollar to lose in international value and will increase the price of alternative investments, such as gold.
* With the recent devaluation of many international currencies, the U.S. dollar was the international safe haven of last resort. We are seeing signs of this ending due to many financial factors, the most important one being a falling dollar.
* There are over One Trillion dollars ($1,500,000,000,000) of U.S. debt owned by foreigners which could be repatriated under certain conditions. This could cause a major decline in the value of the dollar and a soaring gold price.
* If you believe in ‘buy low, sell high’, gold is still low, but climbing.

What is the tax treatment?

Though Gold funds are similar to mutual funds, they are not treated at par with equity schemes. So you don’t enjoy the same tax-free treatment. Both short and long term capital gains tax, with indexation benefits, become payable.

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