What are Exchange Traded Funds or ETFs?

3 Jun 2019  Read 1303 Views

ETFs are mutual funds which are listed and traded on stock exchanges like shares. ETFs are listed on a recognized exchange and their units can be bought and sold directly on the exchange through a stockbroker during the trading hours.

An ETF is a basket of stocks that reflects the composition of an Index, like S&P CNX Nifty or BSE Sensex. It can contain many types of investments, including stocks, commodities, bonds, or a mixture of investment types. This is unlike mutual funds, which are not traded on an exchange, and traded only once per day after the markets closes.

Apart from their returns, the efficacy if ETF is measured through the tracking error, which measures how closely an ETF tracks its chosen index. ETFs are not activity managed funds they are passive funds where the fund manager doesn’t select stocks on your behalf. Instead, the ETF simply copies an index and strives to accurately reflect its performance.ETFs are cost efficient; it offers low expense ratios and fewer broker commissions than buying the stocks individually.

Types of ETF –

  • Index ETF – Index ETFs are exchange-traded funds that seek to track a benchmark index like the Nifty and Sensex as closely as possible.
  • Bond ETF – Bond ETFs are a type of exchange-traded fund (ETF) that entirely invest in bonds. 
  • Gold ETF –Gold ETFs is a commodity ETF that gives an option to investors to invest in gold online and can be used to hedge gold commodity risk or gain exposure to the fluctuations of gold itself.
  • Liquid ETF –Liquid ETFs are funds which derives its value from money market securities comprising of government bonds, treasury bonds, call money markets etc.

How does ETF work?

The buying and selling of ETFs is primarily done online in real time at the stock exchange, through a broker. There is minimal interaction between investors and the fund house.Just like a stock, an ETF has a ticker symbol, and intraday price data can be easily obtained during the course of the trading day. The ability of an ETF to issue and redeem shares on an ongoing basis keeps the market price of ETFs in line with their underlying securities.

Though designed for individual investor, institutional investors play a key role in maintaining the liquidity and tracking integrity of the ETF through the purchase and sale of creation units.

When the price of the ETF deviates from the underlying asset value, institutions utilize the arbitrage mechanismwhich usually involves buying an asset when it is under-priced or tradingat a discount and selling an asset that is overpriced or trading at a premium. This bring the ETF price back into line with the underlying asset value.

Advantages –

  • Lower expense ratio ETF have lower expense ratio than traditional mutual funds as holders don’t need to pay a manager and a team of analysts and brokers to buy and sell funds on their behalf, nor to manage fund inflows and outflows.
  • Liquidityitoffers anytime liquidity through the exchanges i.e., Buy and sell any time during the market hours.
  • Tax advantages due to fewer capital gain; the managers of actively managed funds sell securities and buy new ones every time they have a better investment idea. ETF on the other hand, only sell shares when new securities get dropped from the index, and buy shares only when they are added to the index.

Disadvantages –

As ETF tracks an index closely, so its prices are linked to index level. It means ETFs can yield onlyaverage returns offered by the indices and cannot outperform the index. However, unlikedeveloped economies, Indian market is not very efficient and beating Market in India is easy. So,developing countries like India offers bigger growth prospects and actively managed funds caneasily outperform ETF’s returns.

ETF vs. Mutual Funds

  • ETF and Mutual Funds are almost same, but the main difference is ETFs are traded in the exchange market. In ETF there is more transparency as compared to Mutual funds. The expense ratio is also low in ETF in contrary to mutual funds as MFs are actively managed i.e., the fees and expenses of fund management is high.
     
  • In a mutual fund, the buying and selling of shares proceed from the fund house. Conversely, in ETF the trading is done between two investors in the secondary market.ETFs are considered more tax efficient than mutual funds because due to frequent trading their capital gains tax is higher.The Brokerage is paid in ETF but not in mutual fund as ETFS are traded in stock exchange. ETFs are passively managed funds as they tend to match a specific index, mutual funds are actively managed by fund manager, i.e., the assets are continuously bought and sold in order to outperform the market.

ETF vs. Index Funds

  • In index fund the fund manager just creates a portfolio that exactly replicated an index (nifty or sensex). No element of stock selection is there. The only concern of fund manager is that to ensure that there is minimum tracking error, so the performance of index fund replicates the closely with the index. On the other hand, ETF is fractional share of the index. ETF is almost alike to a close ended fund where the funds are raised in the beginning and then ETF create a portfolio of index, it usually trades at 10% of the index value. E.g. If Nifty is at 6400, a Nifty ETF would cost about Rs. 642 roughly.
  •  ETFs are more liquid as compared to Index Funds as they are listed on the exchange and are easily bought and sold.Index Fund being mutual fund is available for purchase and sales only at the EOD (decided at the close of every trading day) NAV. Because ETFs are listed on the stock exchange, their NAV is revised in real time depending on demand and supply forces.
  • The expense ratio of Index fund is more as compared to ETFs as the fund manager charge money management fee, agent commissions, registrar fees, and selling and promoting expenses. However, since ETFs are bought and sold on the exchange, the addition cost like brokerage, STT and statutory charges need to be considered in getting the correct picture.
  • The tracking error is higher in index fund as some part of an Index Fund can be retained as cash to facilitate redemption. On contrary, tracking error is lower for an ETF because transactions happen over the exchange and there is hardly any requirement of keeping cash for redemption.
  • Regular Investing is possible in Index Funds through SIP. However, when it comes to ETFs the benefit of SIP is not available as it is like a closed-ended fund.There is also a difference in management of dividend pay-outs. In ETF the dividends are directly credited to the registered bank account there is no Dividend reinvestment plan/growth plan. Whereas, in case of index fund the dividends are automatically substituted by units.

How can you buy?

  • To invest in ETFs,an investor needs to have a share trading and demat accounts; because they are traded just like shares in stock exchange.
  • Buying an ETF is just like buying a share. The investor can placea buy or sell order through hisbroker’s trading terminal orthrough the broker by telephonic mode. The ETFs units will be in demat form after the trading settlement.
About the Author: Koushik Mohan | 25 Post(s)

Koushik Mohan has completed MBA from National institute of securities markets (SEBI), with 1.6years of experience working with Northern Trust and CA firm in the departments like OTC derivatives and Accounting.

Liked What You Just Read? Share this Post:

Finology Blog / Invest / What are Exchange Traded Funds or ETFs?

Wanna Share your Views on this? Comment here: