Exchange-Traded Funds (ETFs)

The term ETF has gained a lot of popularity over the past decade not only in developed economies, but in emerging economies such as India as well. However, there is still a lot of ambiguity about how ETFs work or how to go about selecting or investing in them. In this article, we cover the basics of ETFs and also highlight their advantages and disadvantages.

What are ETFs?

ETFs or Exchange Traded Funds are like mutual funds. Both ETFs and mutual funds use a pool of investments from various investors, to purchase a mix of many different assets and represent a common way for investors to diversify.

An ETF is generally a basket of securities which tries to replicate the performance of a particular index, commodity, or a pool of assets. Although, an ETF can be actively managed, but there are very few ETFs are actively managed globally. Active management implies that there is financial expert or fund management team which takes active calls to outperform the market or benchmark by determining over or undervalued (which are currently higher/lower than their actual prices) stocks by his/her own analysis for which they charge a particular fees (such as commission). Passive management simply tracks a particular index and there is no active management involved in creating portfolios.

One major difference between ETFs and mutual funds is in the way that they are traded. While mutual funds can be sold to or purchased from the Asset Management Company (AMC), ETFs on the other hand are traded like shares on the stock market.

This primary difference leads to another important difference between ETFs and mutual funds – pricing. Since ETFs can be purchased and sold on the stock exchange at any time when the markets are open for trading, their price is dynamic and changes through the trading day. On the other hand, mutual fund pricing is set daily, based on the NAV (Net Asset Value) of each unit.

Since ETFs are traded on the exchange, the counterparty is another investor looking to take the opposite trade. However, in case of mutual funds, the counterparty is the mutual fund house or AMC.

Given the fact that ETFs are generally passively managed, the fees or expense ratios on these are relatively lower. However, trading on these does entail a brokerage cost.

Key Differences between ETFs and Mutual Funds

Types of ETFs

Equity ETFs – Equity ETFs are those exchange-traded funds which try to replicate either a broader and more diversified market index (such as the Nifty 50 or Sensex) or a specific sector index (Banking or IT, etc.). This type of investment is an inexpensive way to achieve diversification in portfolios.
Bond/ Fixed Income ETFs – Fixed income ETFs (bonds & bonds ETFs) are ETFs that invest in fixed income instruments. A recent example of a fixed income ETF is the Bharat Bond ETF which invests in bonds of government-owned public sector companies. Fixed income ETFs are advised to be a part of one’s portfolio to reduce the overall volatility while providing a stable source of income.
Commodity ETFs – These ETFs invest their assets in various commodities. The most popular commodity for ETF investing is gold. Commodity investing can provide a good diversification to the overall portfolio, as commodities generally have a negative correlation with equities and bonds. Gold ETFs can also work as a hedge against inflation.
Currency ETFs – Though not very popular in India, currency ETFs do capture a fair market share in developed markets. As the name suggests, these ETFs invest in a currency. Investment in a currency ETF provides both speculative as well as hedging benefits for any future obligations in a particular currency.
Others – There are a few more types of ETFs that have not really taken off in terms of popularity, such as Real Estate ETFs and specialty funds.

Advantages & Disadvantages of ETFs

Following are the advantages of investing in ETFs:

Lower Cost: In terms of cost savings, ETF plays a major role as it is passively managed, and the cost involved with regard to management fees or other related costs is much lower than active mutual funds. However, one must take into account the brokerage on the purchase or sale of ETFs.
Flexibility: The ETFs prices trades throughout the day which offers great flexibility and liquidity to the investors.
Dividends: Usually, in mutual funds, the dividends are reinvested for further returns but in ETFs, the dividend usually becomes cash flow for the investor.

Following are the disadvantages of investing in ETFs:

Demat Account: In order to trade in the secondary markets, be it in stocks or in ETFs, one needs to hold a Demat account. In the case of mutual fund investments, there is no obligation to open a demat account.
Liquidity Risk: Even though ETFs can be traded through the day, one can only purchase or sell ETF units if there is a counterparty available. In case of mutual funds, the AMC is the counterparty and hence there is no risk involved to this extent.
Transaction Cost: The earlier point regarding liquidity risk leads to high transaction costs. Since volumes on ETFs in India is still low, the absence of buyers and sellers leads to high bid-ask spreads. This makes trading ETFs unviable.
No Alpha: For investors looking to beat the market returns ETFs are not the most preferred product as they only replicate the index.

How to buy and sell the ETFs?

To buy or sell the ETFs, an individual needs to have a Demat account. Same as the shares, an investor cannot buy or sell the ETFs without the Demat account. There are many brokers and an individual can open their Demat account with any of the brokers to buy or sell the ETFs.

Examples of ETFs

There are many ETFs available in India for investments. Some of the examples are mentioned below:

Motilal Oswal NASDAQ 100 ETF.
ICICI Prudential Midcap Select ETF.
Nippon India ETF Gold Bees.
Kotak Sensex ETF.
SBI - ETF Nifty 50.
Edelweiss ETF - Banking.
HDFC Banking ETF
Nippon India ETF Nifty IT

Conclusion

Even though ETFs have several distinct advantages, they are still not the preferred vehicle for investing in India. This is largely owing to the low traded quantities and lack of knowledge within the investor community. One must consider the high transaction costs involved in terms of bid-ask spreads before considering investments in ETF. In case an investor is seeking average market returns, they may consider low-cost index funds as they provide good liquidity and low risk at a reasonable cost.

Frequently Asked Questions (FAQs)

1. What are ETFs?

ETF stands for Exchange Traded Fund. ETFs are also like mutual funds as they also pool the investment from different investors and invest in listed securities as per the objective of the fund. The AMCs allot units of the ETF to investors in respect of their investment amount.

2. How can we buy and sell the ETFs?

An individual needs to have a D-mat account to buy or sell the units of ETFs. Without a Demat account, it is not possible to buy or sell the ETFs. The buying and selling of ETFs can be easily done through any stockbroker.

3. Are ETFs also as liquid as mutual funds?

Yes, ETFs also carry good liquidity. However, the units can only be sold if there is a counterparty available which is unlike mutual funds, where investments can be liquidated more easily as the AMC itself is a counterparty there.

An investor can sell the units at any time on the exchange and get the amount credited into their bank account. But one of the limitations of ETFs is that they can only be bought or sold during the stock market hours.

4. Are ETFs and Share prices the same?

No, ETFs and share prices are totally different. ETFs reflect the per-unit value of a unit while incorporating the underlying assets whereas the share price reflects the per-share value of the company.

5. Do ETFs pay a dividend?

No, ETFs do not pay dividends. If the underlying security pays any dividend, then that dividend amount will be added to the underlying value of the asset and thus will lead to an increase in the unit value of an ETF.

6. How are ETFs different from mutual funds?

There are some major differences between ETFs and Mutual funds. One of the differences between both is that ETFs are traded on stock exchanges and can only be bought or sold through the stock exchange. Whereas, the mutual funds do not trade on stock exchanges and hence not require a demat account for making investments.