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WHAT ARE EXCHANGE TRADED FUNDS (ETF)?


The way you buy mutual funds is usually very different from how you buy shares.

If you wish to buy a mutual fund, you must buy it through the mutual fund house (you can route your transaction through a broker or approach the mutual fund directly). The fund house allocates the units to you based on the NAV (Net Asset Value) of the same day or the next, depending on your time of investment.

This is different from how you buy shares. You can buy shares directly from the market at any time during trading hours at the price prevailing at the time.

Exchange Traded Funds are mutual funds with one difference. You can buy and sell them like shares at any time during the day.

Let us look at this in greater detail.

WHAT IS AN ETF?

Exchange Traded Funds are mutual funds that can be bought and sold like shares on the stock exchanges during trading hours. That’s their biggest advantage over traditional mutual funds and the reason why many investors opt for ETFs.

ETFs may hold a variety of asset classes in their portfolio – be it commodities, bonds or equities. Often, an ETF is based on an index such as the Nifty or the Bank Nifty. In fact, most index funds are ETFs.

Exchange Traded Funds are an attractive option because of the low costs and ease of trading. However, only authorized participants, large brokers or dealers who have entered into an agreement with an ETF distributor, can trade them.

WHAT ARE THE FEATURES OF ETF (EXCHANGE TRADED FUNDS)?

ETFs are unique in many ways.

  • ETFs typically track an underlying index or security. The price of an ETF moves in tandem with the underlying.

  • ETFs are a good investment option for small investors. The fund managers ensure that the ETF prices are kept close to the underlying securities.

  • Exchange Traded Funds are transparent – since they replicate the performance of an underlying index or commodity. Investors know exactly what they are buying.

  • ETFs have a low expense ratio compared to a traditional mutual fund because they are passively managed.

HOW DOES AN ETF WORK?

Now that you know what is an ETF, let’s talk about how it works. ETFs are traded by authorised participants who are typically appointed by Asset Management Companies or AMCs. The authorised participants follow these steps while investing in ETFs.

  1. Authorised participants deposit shares comprising the index with the AMC.

  2. In return for the shares, the AMC issues ETF units to the authorized participants (these units are called ‘creation units’).

  3. The authorised participants are free to hold these units themselves or break them up into smaller units and trade them on the market.

  4. Retail investors buy these units directly from the exchanges.

Authorised participants may deposit more shares with AMCs, when the demand increases, by creating fresher units to meet the increasing demands. Also, if the redemption of ETFs increases, the authorised participants may return units back to the AMC and take their shares in return. These shares are then sold in the share market and the investor is paid back his money. Unlike with mutual funds, all ETF trades happen in real time, which is why the effort and the cost of ETF trading are minimal.

TYPES OF ETFS

There are various types of ETFs. They are as under

  • Index ETF

  • Gold ETF

  • Bank ETF

  • Liquid ETF

  • International ETF

Now let us look at each one of them briefly.

  • Index ETF: Index Exchange Traded Funds are among the oldest of ETFs. They are also the most commonly traded ETFs. Such ETFs track the performance of an index by mirroring the basket of stocks that make up the index. These ETFs hold securities in the same proportion as in the index. These funds are further divided into two types:

    • Representative ETFs – these invest a major portion of the fund in representative samples, whereas the remaining portion is invested in other holdings such as options, futures etc.

    • Replication ETFs – these entirely invest in securities underlying the index.

  • Gold ETF: Investors looking to participate in the gold bullion market, without purchasing physical gold and taking its delivery, can invest in Gold ETFs. You can buy and sell Gold ETF units on the stock exchange in real time. While physical gold investments require huge sums of money, you can invest in gold ETFs in small denominations, by opting for Systematic Investment Plans (SIPs). Gold ETF prices reflect those of physical gold. Every time the price of gold appreciates, so does the value of the ETF.

  • Bank ETF: Bank ETFs are those which invest in stocks of banks that are listed on an index like the Bank Nifty. Sectoral ETFs like the Bank ETF are highly volatile since they are focused on a single sector.

  • Liquid ETF: These are ETFs that attempt to enhance returns while minimising risks. Liquid ETFs basically invest in a basket of call money, money market instruments and short-term government securities, usually of short duration.

  • International ETF: ETFs which invest in foreign-based securities are regarded as international ETFs. These ETFs are passively invested around underlying indices (such as the NASDAQ 100). Certain international ETFs, particularly those that have a global footprint provide strong diversification as they invest in several companies across borders.

CRITERIA FOR SELECTING AN ETF

Other than understanding what is an ETF, you should also consider certain criteria before you select an ETF. These include:

  • The cost of the ETF: Even if two diverse ETFs are tracking the same market, the cost ratios among them may vary to a great extent. As such, other things being equal, choose those ETFs which come with lower expense ratios keeping in mind that the cost of the ETF can directly affect the returns you earn.

  • The benchmark of the ETF: Before an investor finalizes an ETF for investment purposes, he must first determine the market as well as the market segment or the sector of the industry in which he would like to invest. Investors must remember that every index has its own construction methodology, which results in huge variations in the characteristics of the portfolio. Even two benchmarks, which are tracking the same segment of the market, can deliver diverse results.

  • Tracking error: Most ETFs are based on an underlying index or asset. Tracking error measures how accurately an ETF tracks the underlying. The higher the tracking error, the less the ETF reflects the underlying.

Other important criteria for ETF investments include the strategy employed by the fund manager, the fees and expenses charged by them, the size of the ETF, and how they are structured.

WHO SHOULD TRADE IN ETFs?

ETFs can be traded by a broad class of investors. ETFs are especially popular among large institutional players who are comfortable pursuing aggressive strategies. Retail investors and small institutions, who generally trade in small lots, can also invest on the same terms.

  • Invest in ETFs if you are looking for exposure to broad swathes of the market. For example, a sector fund tracking Bank Nifty will give you exposure to the entire banking sector. An ETF based Nifty 50 could potentially give you a basket of India’s biggest stocks.

  • Invest in ETFs if you are looking for stable returns at low cost.

  • Invest in ETFs if you want the liquidity of shares and the benefits of a mutual fund rolled into one. After all, you can liquidate your units any time during trading hours.

WHAT ARE THE USES OF ETFS?

  • Asset Allocation: Individual investors may find it difficult to manage asset allocation with the right amount of diversification. Such investors can benefit from ETFs which provide them exposure to the broader segments of the equity markets. ETFs cover a wide range of size and style spectrum and enable investors to build customised investment portfolios which are consistent with their financial goals, risk appetite and investment horizon. Both, individual as well as institutional investors use ETFs to allocate their assets in an efficient, convenient and cost-effective manner.

  • Cash Equitisation: Every investor basically seeks exposure to equity markets. However, they generally require some time when it comes to making investment decisions. Such investors can take advantage of ETFs which provide them with a “place to park” their cash meant for equity investments. Since ETFs are liquid, investors can continue their market participation, while they take time to decide where they can invest funds for longer terms.

  • Arbitrage and covered option strategies: ETFs can also be used to arbitrage between Cash and Futures Market, since they are very easy to trade. Additionally, ETFs are used for cover Option strategies on the Index.

WHAT ARE THE ADVANTAGES OF EXCHANGE-TRADED FUNDS?

Below are some of the advantages of the ETF:

  • Unlike traditional stocks, the Exchange Traded Funds can be traded throughout the day. They provide an opportunity for speculative investors to bet on the direction of shorter-term market movements.

  • Exchange Traded Funds shine when it comes to saving money. They offer all the benefits of a listed stock and come at a much lower cost than a traditional mutual fund.

  • Exchange Traded Funds come in handy when investors want to create a diversified portfolio.

  • ETFs can provide stability in volatile markets.

DISADVANTAGES OF EXCHANGE-TRADED FUNDS

Although Exchange Traded Funds advantages look promising, the cons cannot be ignored:

  • Most ETFs are passively managed. They must track an underlying security or index. This is an advantage in terms of costs, as it allows a fund to keep the expense ratio low. However, actively managed funds have the advantage of being able to churn their portfolio and make the most of volatility.

  • Even though, in principle, you can buy and sell ETFs at any time during trading hours, some ETFs are illiquid and have low volumes. As a result, you may not find buyers when you want to sell your units.

Now that you know both sides of investing in ETF, you can decide if it is right for you.

If you still are confused about ETFs, ARQ, our artificial intelligence- based investment engine, will help you choose the right fund. Choose the smarter way to invest. Download the Angel BEE app and start investing right away!


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