An Exchange Traded Fund (ETF) is a fund that trades on an exchange, just like a stock and replicate the portfolio and performance of a publically available Index. ETFs offer low expense investment solution.
What is ETF?
An ETF is a basket of stocks that reflects the composition of an Index, like the Sensex or the Nifty. ETF prices reflect the net asset value of basket of stocks in which it is investing. In many ways, it is similar to mutual funds. Exchange Traded Funds (ETFs) are actually Index Funds that are listed and traded on exchanges like stocks and are passively managed. Mutual funds aim to generate alpha by outperforming a market benchmark, whereas ETFs aim to track the relevant index and replicate it returns. To invest in ETFs you need to have demat and trading account with a stock broker.
How to select ETFs and Index Funds?
There are mainly three parameters which investors should look at while investing in ETFs:-
- Total Expense Ratio: Low risk (arbitrage theoretically means risk free profits)
- Tracking error:Tracking error is the deviation between index return and the ETF return. This is an important performance parameter because as an investor you are actually investing in the index.
- Liquidity:This is an extremely important factor for ETFs because unlike mutual funds, ETFs are bought and sold in the stock exchanges. If an ETF is not very liquid, you may not find enough buyers when you want to sell your ETFs.
Some of the popular ETF category schemes are as follows:-
Index ETFs are the most common of all ETF product offerings. It aims to track a particular market index like Sensex, Nifty, BSE 100, Nifty 100 etc. Index ETFs invest in a basket of stocks which replicate the Index the ETF aims to track. When investing in an Index ETF you should expect to get the index returns which your ETF is tracking, nothing more or nothing less.
Investors can buy gold as financial asset in the form of Gold ETF. Gold ETF is an exchange traded fund that aims to track the price of gold in the market and has the same value as that of pure 24 carat physical gold. Like shares of a company, the units of the Gold ETFs are also traded on the stock exchange.
Bank ETFs invests in a basket of banking stocks listed on the stock exchanges.
An International ETF invests mainly in foreign based securities. These ETFs may track global markets or track a country-specific benchmark index. These ETFs can be a good investment option if you want to diversify your investments into foreign securities.
Liquid ETFs invest in a basket of short term Government securities, call money or money market instruments of short term maturities. The objective of liquid ETFs is to enhance returns and reduce price risk.
Why invest in ETFs?
ETF may be a better choice
There are a number of factors that play a crucial role in determining future performance of a mutual fund scheme, for example - fund manager’s track record, AMC track record, long term performance etc. It takes considerable skills to identify a good fund that may outperform its peers and also the market in the future. Exchange Traded Funds, on the other hand, tracks only the Index that it is benchmarking and therefore, there is little scope of outperformance or underperformance. If you aim for market/ Index returns for your investment, the ETFs may be a good choice.
Performance is the focus
The indices, which by their method of construction based on market capitalization, eliminate or at least, reduce the weight of underperformers in the index portfolio. Therefore, by extension ETFs also eliminate or at least reduce the weight of underperformers in their portfolio.
Mutual funds are subject to two kinds of risk – Systematic and Unsystematic risks. Systematic risk is unavoidable because equities as an asset class are volatile. Both ETFs and actively managed funds are subject to market risks. Unsystematic risk is company specific risk or sector specific risk. Though mutual funds aim to reduce unsystematic risk by diversifying its portfolio across stocks and sectors, they still have some residual unsystematic risks because actively managed funds may be over-weight on certain stocks and sectors versus the index. Exchange Traded Funds do not have any unsystematic risk because they simply track the index; therefore, it is a good investment option if you want to totally avoid unsystematic risk.
The expense ratio of ETFs is much lower than their mutual fund counterparts. The expense ratios of ETFs can be as low as 0.25%, compared to the expense ratio of mutual funds which are usually in the range of 1.5% - 2.25%. Unless the mutual funds generates considerable alpha in the long term, they may not be able to beat the ETF returns in the long term.
ETFs bring simplicity to your investing compared to actively managed funds. You do not have to analyze past performance or understand the fund manager’s investment style or how the fund has done in up and down markets etc. Most ETFs track the large cap indices like Nifty, Sensex, BSE – 100, Nifty 100, Nifty Next 50 etc. You can simply select an index and invest in a low cost ETF, which tracks that index and your job is done.
EWithout having a trading and demat account with a stock broker, you cannot invest in ETFs. However for any reason, if you are unable to open a trading and demat account, you can invest in “ETF like” investment products where you can invest in a passive fund which tracks an index. These are called Index funds which like ETFs aim to track a particular index like Sensex, Nifty, BSE – 100, Nifty 100, Bank Nifty etc. The fundamental attributes of index funds are like ETFs however Index funds are not listed on the exchange, while the investment process (purchase and redemption) is just like any other mutual fund scheme. The expense ratios of index funds are slightly higher than ETFs.
ETFs are open ended schemes which try to replicate the return of an Index it is tracking. The fund has to invest minimum 95% of its total assets in securities of the Index that it is tracking.
ETFs can be bought and sold only on stock exchanges on a continuous basis like stocks. Unlike mutual funds where the prices (NAV) are declared at the end of the day, ETF prices keep changing during the entire trading session. At the end of the day, however, you will get the closing NAV of the ETF.
- In mutual funds, the AMC acts as counterparty to the investor. Investors do their buy / sell transactions with the AMC whereas ETFs are listed on stock exchanges like shares. Investors can buy or sell ETFs in the stock exchange at a real time price.
- Mutual fund NAVs are priced at the end of the day. However, just like shares, ETF prices change real time throughout the day based on demand and supply in the market.
- You can invest in mutual funds directly through AMC or through an AMFI certified mutual fund distributors (MFD). However, to invest in ETFs, it is mandatory to have a demat and trading account with a stock broker.
- ETFs do not aim to create alpha over the benchmark index that it tracks; it aims to replicate the returns of the benchmark index.
- Being passive funds, the ETF expense ratios are much lower compared to actively managed mutual fund schemes.
- Many investors use ETFs and index funds synonymously which is not correct. Though there are few similarities between them, the investors must understand the differences between the two. The most important difference between index fund and ETF is that, index funds are mutual fund schemes to invest in which you do not need demat or share trading account since they are not listed on the exchange. You can buy index funds directly from the AMC or through a MFD like any other mutual fund schemes. But to invest in ETFs you must have demat and share trading account.
- ETFs are cheaper than index funds. If you buy ETFs there is no securities transaction tax (STT), but when you sell then STT is applicable. Also, you have to pay brokerage every time you buy and sell ETFs. In addition to STT and brokerage, investors also have to pay charges for the demat account for holding the ETFs in electronic form. Index funds can be bought just like any other mutual fund scheme but their expense ratio is slightly higher than Exchange traded funds.
- Some investors may buy or sell an ETF in the Futures and Options (F&O) market, with a much lower capital outlay compared to a basket of stocks. Given current lot sizes in the NSE and margin requirements, minimum capital outlay in ETFs will still be much lower compared to futures.
- While Futures and options have expiry dates (last Thursday of the month), ETFs have no expiry date. You can invest in ETF and hold it as long as you want. In summary, F&O are trading products, whereas ETFs are investment products.
- In F&O you can take a much bigger position with a smaller capital outlay. While your profits may be high, your losses can also be high. F&O positions are marked to market and in case of market correction; investors may have to provide additional money for maintaining margin even before expiry. ETFs are not leveraged positions and hence there is no margin requirement. During market correction, your ETF NAV will fall but you will not have to pay any additional money. Risk in ETF is therefore, much lesser than futures.