By Chintan Haria
As an investor, you have multiple choices today while making an investment decision. You have the option to choose from a wide variety of investment vehicles spread across the risk-return spectrum. Generally, investors who are looking for stable returns and want to protect the downside of the portfolio gravitate towards debt investments. On the other hand, investors who want to grow their portfolios and generate long-term returns opt for equity investments. Equities offer investors the option to invest in stocks of companies that can potentially witness good growth. Today, there are several ways in which one can invest in the equity market. Here we are comparing two such options – direct equity investing and investing in index-based exchange traded funds (ETFs).
In order to arrive at the best investment decision, you need to ensure that the approach adopted is best suited to your requirement and risk profile. Below, is a comparative analysis that can shed light on some of the key aspects and help you make an informed decision
Risk
ETF: In the short term, equity prices can witness high volatility and sharp movements. Some of these movements can have a large impact on your portfolio. However, ETFs can mitigate the impact of these movements as they invest in a diversified portfolio and stay invested through the market’s ups and downs.
Direct Equities: When you invest directly in equities, it becomes challenging to ignore daily market fluctuations. As a result, you might react to market movements and make investment decisions that are influenced by sentiment rather than rational thoughts. This acts as a barrier to staying invested for the long-term and reaping the true benefits of equities.
Diversification
ETF: An index ETF invests in all the stocks of the benchmark index and in the same proportion as the index. Generally, a benchmark index tends to be well-diversified across sectors and industries, thereby ensuring that sharp movements in any one sector or company do not have a large impact on overall returns. Since ETFs replicate an index, they too provide the same diversification benefits.
Direct Equities: When you build a portfolio by directly investing in stocks, it can be challenging to ensure optimal diversification. Not only do you need to ensure that the number of stocks you hold in the portfolio are sufficient, but you also need to make sure that the exposure through these stocks is across multiple sectors and industries.
Returns
ETF: This provide market-linked returns adjusted for tracking error and fund management costs. For example, a Nifty50 Index ETF will hold all 50 stocks in a similar proportion as the index. A BSE500 ETF will hold the 500 stocks in a similar proportion of their index weight. As a result, the performance of the ETF will closely mirror that of the index. By investing in ETFs, one can get market-linked returns with no additional stress of security selection.
Direct Equities: When investing directly in equities, returns can be highly volatile and can fluctuate as much as individual stock prices. While the returns may look good on stocks which do well, the stocks which do badly can significantly bring down overall portfolio returns.
Research
ETF: When you invest in an ETF, the stock selection is based on a pre-decided, transparent methodology available on the index provider’s website. The method may reflect broad market weighted indices, smart beta indices or sector indices. Investors get to choose a diversified bouquet with predefined selection criteria.
Direct Equities: When you invest directly, the onus of stock selection and research falls upon you. This means that you need to have the time and inclination to read company annual reports, research reports, and listen to company conference calls to choose the potentially ‘winning’ stocks. It may put a lot of emotional pressure on the investor too.
Cost
ETF: It generally has low fund management expenses, since it replicates an underlying index and needs to buy/sell only when there is index rebalancing activity.
Direct Equities: Buying and selling stocks will have many costs. Some of the tangible ones are brokerage and capital gains, while the intangible ones include impact cost and liquidity costs.
On the basis of these parameters, ETFs may score over direct equity investing for most investors. Whether you are a new investor who wants to slowly gain exposure to equities or a seasoned hand who wants to benefit from the growth potential of equities, ETFs can be one of the cost efficient ways to gain the required exposure to equities.
(Chintan Haria is Head of Product Development & Strategy at ICICI Prudential AMC. Views are his own)
