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Asset management companies (AMC) over the last five months have started to focus on passive funds, which include index funds and exchange-traded funds (ETFs), as actively-managed large-cap funds especially are finding it difficult to beat the benchmark over the past few years.

As much as 86.2% of Indian equity large-cap funds, 57.1% of mid- or small-cap and 53.7% of the equity-linked savings scheme or (ELSS) funds underperformed their respective benchmarks for the one-year period ended June 2021, according to the latest S&P Indices Versus Active (SPIVA) India scorecard report.

Over the past few months, ETFs have grabbed the limelight. Leading stock exchange, National Stock Exchange of India (NSE), in July said that the number of ETFs listed on its platform has hit a tally of 100.

“Many of the active funds have started to underperform for quite some time. Also, AMCs would want to maintain their inflows in some fashion. The passive strategy has been in flavor over the past few years and the fund houses have launched some unique investment themes as well," said Rushabh Desai, a Mumbai-based mutual fund distributor.

Moreover, since the start of the financial year, fund houses have launched a total of 11 ETFs in the Indian market. Even HDFC Asset Management Company Ltd filed papers for nine ETFs with the Securities and Exchange Board of India (Sebi) within a span of two days in the first week of October.

An ETF, or exchange-traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. ETFs are funds that track indexes such as Nifty or Sensex. The main difference between ETFs and other types of index funds is that ETFs don't try to outperform their corresponding index, but simply replicate the performance of the Index.

On the other hand, an index fund works like a mutual fund scheme, in which a fund manager creates a portfolio that replicates an index, which could be Sensex or Nifty. But index funds can buy them only at the end of the day's net asset value (NAV).

“I usually don’t recommend my clients to venture into ETFs because of two factors. First is that ETFs can be traded at a premium, and there can be a price dislocation between the actual price and the traded price. So, investors can bear certain opportunity losses. Second is that there can be liquidity issues when the investor wants to get out of the issue," said Desai.

The expert added that if there is no unique theme available in the index category, then and then only one should get into ETFs.

Unlike index funds, one key advantage of ETFs is that they are traded like common stock, and can be bought or sold on the stock exchange.

However, investors must be aware of the tracking error in the ETFs, which is the difference between the returns of an index and the fund tracking it. A higher tracking error shows that the fund is not replicating the index truly due to higher cash or expense levels or different allocation to stocks. This exposes it to the risk of deviating from its mandate.

Low-cost passive investments such as index funds and ETFs are good long-term choices, but make sure that you are getting advantages of low-cost, efficient transactions in the instrument that you have chosen.

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