Mutual Funds, ETFs and SIPs

How pooled funds work, the difference between active funds, index funds and ETFs, what a SIP does and does not do, and the costs that decide the outcome.

Most people who invest in Indian equities do not buy individual shares. They buy a pooled vehicle: a mutual fund or an exchange-traded fund. The choice is not a shortcut around learning about markets; it is a different set of decisions, and the decisions are mostly about cost, mandate and behaviour.

This lesson explains what a pooled fund is, how mutual funds and ETFs differ, what a systematic investment plan (SIP) actually does, and which costs decide the outcome over long periods.

What a pooled fund is

A mutual fund collects money from many investors and buys a portfolio of securities with it. Each investor owns units of the fund, not the underlying shares directly. The fund is managed according to a stated mandate, and the units are priced at the fund’s net asset value.

Net asset value (NAV) is the value of the fund’s assets minus its liabilities, divided by the number of units outstanding. For open-ended mutual funds, NAV is calculated at the end of each business day. You buy and redeem at that NAV, not at a live market price.

The mandate matters more than the name. A “large cap” fund should hold large companies, a “mid cap” fund mid-sized ones, a “debt” fund bonds. Read the scheme information document and the monthly portfolio disclosure if you want to know what is actually held. A fund can drift from its stated style, and the label does not enforce the holdings.

Active and passive

Active funds employ a manager who selects securities, aiming to beat a benchmark. They charge more, because research and trading cost money. Whether the outperformance covers the fee is an empirical question, and the evidence in most developed markets is that most active funds underperform their benchmark net of costs over long periods. India is a large and less efficient market, so the result is less one-sided, but the fee still has to be earned.

Passive funds track an index. An index fund holds the constituents in the index weights and aims to match the index return, before costs. Because there is little research and less trading, the expense ratio is lower. The result is the index return minus costs, which is the point: you are not trying to beat the market, you are trying to own it cheaply.

Index funds are bought and redeemed from the fund house at end-of-day NAV, like any mutual fund.

Exchange-traded funds (ETFs) are also passive, but their units trade on an exchange throughout the day like a share. You buy from another investor at a market price, not from the fund at NAV. That introduces two things a mutual fund does not have:

• Price versus NAV. An ETF’s market price can trade slightly above (premium) or below (discount) its NAV. For large, liquid ETFs the gap is usually small; for thin ones it can be meaningful.
• Liquidity. A large ETF with many buyers and sellers is easy to trade. A small one may have a wide bid-ask spread, so your entry and exit cost more than the expense ratio suggests.

Tracking error is the standard measure of how closely a fund follows its index. A low tracking error means the fund is doing its job. A fund that consistently trails its index by more than its expense ratio is losing money to something other than the fee.

Costs, which compound

Costs are the most reliable predictor of relative performance, because they are known in advance and they compound against you.

• Expense ratio (total expense ratio, TER): the annual percentage deducted from the fund’s assets. It is already reflected in the NAV, so you do not see a separate bill.
• Direct versus regular plans: a regular plan pays a commission to a distributor, which is included in its expense ratio. A direct plan bought from the fund house or a platform has a lower expense ratio and the same portfolio. Over twenty years the difference is material.
• Exit load: a fee for redeeming within a stated period, often one year for equity funds. Read it before you buy, not when you sell.
• Brokerage and spread: for ETFs, the cost of trading, which can exceed the expense ratio for a small purchase.
• Taxes: the treatment depends on the fund’s equity exposure and your holding period, and the rates change. Our taxation lesson sets out the framework; check the current rules before you sell.

A one percent difference in annual cost does not sound like much. On a long holding period it is a large share of the final value, because the money that goes to costs never compounds for you.

What a SIP does

A systematic investment plan (SIP) is a standing instruction to invest a fixed amount at a fixed interval, usually monthly. It buys more units when the NAV is low and fewer when it is high, so the average cost per unit over the period is below the average NAV. This is called rupee-cost averaging.

What a SIP does:

• It removes the decision of when to invest, which removes a common source of bad timing driven by emotion.
• It spreads purchases across market levels, so a single bad entry point matters less.
• It builds a habit, which for most people is the largest single factor in whether they invest at all.

What a SIP does not do:

• It does not guarantee a profit. A SIP into a falling market loses money for as long as the fall continues.
• It does not make an expensive fund cheap. A high-cost fund remains high-cost on every instalment.
• It does not remove the need to choose an appropriate fund and an appropriate amount.
• It does not beat a lump sum in a rising market. If you have a sum to invest and the market rises, investing it early usually wins; the SIP’s advantage is behavioural, not mathematical.

A step-up SIP increases the instalment each year, which matters more than the starting amount for a long horizon.

Choosing a fund, in order

1. Decide the mandate. Equity or debt, large or mid cap, domestic or international. The fund should match the job you are asking it to do and the time horizon you have.
2. Decide active or passive. If you do not have a reason to believe a manager will beat the index net of fees, a low-cost index fund is the default.
3. Compare costs. Expense ratio, direct versus regular, exit load, and for an ETF the spread.
4. Check tracking error for a passive fund, and portfolio concentration for an active one. A fund with 60% in ten stocks is not diversified, whatever its category.
5. Check the fund’s size and flows. A very small fund can struggle with costs and continuity; very large flows can make a strategy harder to run.
6. Read the risk disclosures and the portfolio, not only the past return. Past return is the most advertised number and the least predictive.

Common mistakes

• Chasing last year’s best fund. The top performer of one period is frequently not the top performer of the next, and the flows that follow the ranking make the fund larger and harder to run.
• Holding too many funds. Ten equity funds overlap heavily and produce an expensive index fund with extra paperwork. Three or four with distinct mandates is usually enough.
• Stopping the SIP in a fall. The fall is when the SIP buys the most units. Stopping then converts a temporary loss into a realised one.
• Ignoring the direct plan. The same portfolio at a lower cost is a free improvement.
• Treating the NAV as “cheap” or “expensive”. A ₹10 NAV is not cheaper than a ₹100 NAV. NAV is a unit size, not a valuation.

The honest summary

Pooled funds are a sensible default for most investors, because they provide diversification and professional management at a cost that is now low for passive options. The decisions that matter are the mandate, the cost and your own behaviour. The fund’s recent return is the least useful of the three, and the one most often used.

Our lesson on investing reality sets out what the evidence says about long-run returns. Risk management and position sizing covers how much of your capital belongs in equities at all.