All about ETFs (Exchange Traded Funds)

Exchange traded funds or ETFs have revolutionized the global investment industry in recent times due to their simplicity, low costs and ease of use.

In India, exchange traded funds have been in existence for quite some time now. But they have not been able to attract investors' attention and money unlike its global peers.

The foremost reason for ETFs not being popular among investors in India is the lack of understanding of the concept of ETF.

What are ETFs? How are they different from a normal MF? How does ETF work? Are ETFs worth investing? We look at the answers to these and some other common queries regarding the ETFs.

1. An exchange traded fund (ETF) looks like a mutual fund that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange.

ETFs experience price changes throughout the day as they are bought and sold throughout the trading day. When you buy shares of an ETF, you are buying shares of a portfolio that tracks the yield and return of its native index.

Buying/selling ETFs is as simple as buying/selling any other stock on the exchange allowing the investors to take advantage of intra-day price movements. 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 its performance. ETFs don't try to beat the market, they try to be the market.

2. Convenience: ETFs can be bought/sold any time of the day when the market is open, as they are traded on a real time basis.

Diversification: By investing in ETFs an investor can enjoy the diversification benefits of an index fund with the flexibility of a stock.

ETFs can be bought and sold anytime during market hours at a price which closely replicates the actual NAV of the scheme.

With a small amount of money an investor can get the benefit of an entire underlying asset which could be an Index or a commodity like gold.

Lower expense ratio: ETFs are managed passively. Hence administrative charges are low which pushes down the expense ratio.

Tracking error, which is divergence between the NAV of the ETF and the underlying Index, is generally observed to be low as compared to a normal index fund due to lower expenses and the unique in-kind creation / redemption process.

3. Investors can use ETFs for strategic asset allocation and tactical asset allocation to reflect their short-term investment insights.

Investors can use ETFs to make sector bets or reduce their sector exposure.

Investors can effectively short or hedge Index exposure by selling ETFs against long stock holdings, thereby reducing the broad market risk exposure or beta of the portfolio.

An investor in an open-ended mutual fund can only purchase or sell at the end of the day at the mutual fund's closing price, while ETF is continually priced throughout the day and therefore is not subject to this disadvantage, allowing the user to react to adverse or beneficial market condition on an intraday basis.
Tax efficiency: ETFs generally generate relatively low capital gains, because they typically have low turnover of their portfolio securities. While this is an advantage they share with other index funds, their tax efficiency is further enhanced because they do not have to sell securities to meet investor redemptions.

4. An investor can invest in ETF through AMC or an exchange. Expense ratio for ETFs is generally low but there are certain costs unique to the investors.

As investors can buy or sell ETF in the exchange like stocks, for every transaction he has to bear a brokerage commission. Investors may also have to bear costs related to difference in the ask-bid spread.

But these costs are not related only to ETF, even plain vanilla funds are also charged the same expenditure rather indirectly, as the fund pays for these costs.

5. One of the most important differences between open-ended mutual fund and ETF is that ETF are traded on an exchange on an intra-day basis and an investor can buy/sell ETF units at the prevailing market price.

While in an open-ended mutual fund, NAV is declared once a day and the investor can buy/sell at that NAV only.

6. Though ETFs and Futures provide an exposure to the same underlying index, they also differ on these points:

ETFs trade in much smaller investment sizes than a futures contract, making it possible for retail investors to participate in index investing.

Futures trading require an account with a broker having derivatives terminal and are subject to margin requirements prescribed by the exchanges.

Futures involve significant leverage which magnifies losses in the vent of prices moving against the positions held by the investor.

Futures contracts must be rolled over every three months (or every one month if liquidity is poor in far month contracts) which can lead to higher trading costs and tracking error.

7. Equity ETFs: Equity ETF is a basket of stocks that reflects the composition of an Index, like S&P CNX Nifty or BSE Sensex. The ETFs trading value is based on the net asset value of the underlying stocks that it represents. Think of it as a mutual fund that you can buy and sell in real-time at a price that changes throughout the day. Currently there are eleven equity ETFs which can be traded in BSE.

Liquid ETFs: Liquid ETFs are the money market ETFs, the investment objective of which is to provide money market returns. Liquid BeES launched by benchmark mutual fund is the first money market ETF in the world. Liquid BeES will invest in a basket of call money, short-term government securities and money market instruments of short and medium maturities.

Gold ETFs: Gold ETF is a special type of exchange traded fund that tracks the price of gold. Currently there are six gold ETFs which can be traded in BSE.

8. Gold ETF is a special type of exchange traded fund that tracks the price of gold. Uses of gold ETF:

To keep gold as part of your portfolio, invest in gold ETFs

To accumulate gold for special obligations, and you can sell them to purchase jewellery or other forms of gold when you desire

Advantages of gold ETF

Price approximately equal to 1 gram of gold

Backed by physical gold holding of 0.995 purity

No wealth tax

Long term capital gains after on year

No STT

No storage issues and fear of theft

No need to bear insurance cost

No need to shell out a huge sum of money to purchase ETF units.

9. ETFs trade just like any other normal listed security on the BSE , settlement is just like any other stock.

In case an investor has purchased ETF from the market, he has to pay the broker before the pay-in on T+2 and in the case of sale, an investor has to transfer ETF units from his demat account to his brokers account before the settlement on T+2.

Are ETF's For ME ... . . .??

10. Here are some guidelines to help you know when to consider an ETF and when not.

If you're trying to get market returns or believe the index will yield good long-term returns, ETFs may be a good choice because of their low cost and diversification. But ETFs make little sense if you're trying to beat the market, since they only track market indices.

When you're looking for wide diversification, but have only a small sum to invest, an ETF may make sense.

When you're unsure what to buy but want to invest in equity, an ETF lets you invest in the stock market without betting on a particular company.