Exchange Traded Funds (ETFs)
- What is an ETF?
- What are the costs of investing in ETFs?
- Are ETFs only for stocks?
- How does the in-kind creation / redemption mechanism work in ETFs?
- Why do ETFs trade close to their NAV?
- How do ETFs derive their liquidity?
- What is the difference between an ETF and an Index Fund?
- What happens to the dividends of the underlying stocks?
- What happens if constituents in the underlying index change?
- What is meant by 'Tracking error'?
- What are the benefits of investing in ETFs?
An ETF, or exchange traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund.
In the simple terms, ETFs are funds that track indexes such as CNX Nifty or BSE Sensex, etc. When you buy shares/units of an ETF, you are buying shares/units of a portfolio that tracks the yield and return of its native index. 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 the performance of the Index. They don't try to beat the market, they try to be the market.
Unlike regular mutual funds, an ETF trades like a common stock on a stock exchange. The traded price of an ETF changes throughout the day like any other stock, as it is bought and sold on the stock exchange. The trading value of an ETF is based on the net asset value of the underlying stocks that an ETF represents. ETFs typically have higher daily liquidity and lower fees than mutual fund schemes, making them an attractive alternative for individual investors.
ETFs are passively managed. The purpose of an ETF is to match a particular market index, leading to a fund management style known as passive management. Passive management is the chief distinguishing feature of ETFs, and it brings a number of advantages for investors in index funds. Essentially, passive management means the fund manager makes only minor, periodic adjustments to keep the fund in line with its index. An investor in an ETF do not want fund managers to manage their money i.e., decide which stocks to buy/sell/ hold), but simply want the returns to mimic those from the benchmark index. Since buying all scrips that are part of say, the Nifty (which has 50 scrips) is not possible, one could invest in an ETF that tracks Nifty.
This is quite different from an actively managed fund, like most mutual funds, where the fund manager ‘actively’ manages the fund and continually trades assets in an effort to outperform the market.
Because they are tied to a particular index, ETFs tend to cover a discrete number of stocks, as opposed to a mutual fund whose scope of investment is subject to continual change. For these reasons, ETFs mitigate the element of "managerial risk" that can make choosing the right fund difficult. Rather than investing in an ‘active’ fund managed by a fund manager, when you buy shares of an ETF you're harnessing the power of the market itself.
ETFs are cost-efficient
Because an ETF tracks an index without trying to outperform it, it incurs lower administrative costs than actively managed portfolios. Typical ETF administrative costs are lower than an actively managed fund, coming in less than 0.20% per annum, as opposed to the over 1% yearly cost of some actively managed mutual fund schemes. Because they have lower expense ratio, there are fewer recurring costs to diminish ETF returns.
While the Expense Ratio of ETFs is lower, there are certain costs that are unique to ETFs. Since ETFs are bought traded on stock exchange through a stock broker, every time an investor makes a purchase or sale, he/she pays a brokerage for the transaction . In addition, an investor may also incur STT and the usual costs of trading in stocks, including differences in the ask-bid spread etc. Of course, traditional Mutual Fund investors are also subjected to the same trading costs indirectly, as the Fund in turn pays for these costs.
Flexibility of ETFs
ETF shares trade exactly like stocks. Unlike index funds, which are priced only after market closings, ETFs are priced and traded continuously throughout the trading day. They can be bought on margin, sold short, or held for the long-term, exactly like common stock.
Yet because their value is based on an underlying index scrips, ETFs enjoy the additional benefits of broader diversification than shares in single companies, as well as what many investors perceive as the greater flexibility that goes with investing in entire markets, sectors, regions, or asset types. Because they represent baskets of stocks, ETFs typically trade at much higher volumes than individual stocks. High trading volumes mean high liquidity, enabling investors to get into and out of investment positions with minimum risk and expense.
No. Any asset class that has a published index and is liquid enough to be traded daily can be made into an ETF. Bonds, real estate, commodities, currencies, and multi-asset funds are all available in an ETF format. For instance, Mutual Funds in India offer Gold ETFs, where the underlying investment is in physical gold.
ETFs can either be purchased on the exchange or directly from the Fund. The Fund creates / redeems units only in predefined lot sizes in exchange for a predefined underlying portfolio basket (called “creation unit”). Once the underlying portfolio basket is deposited with the Fund together with a cash component, the investor is allotted the units.
This is in-kind creation / redemption of units, unique to ETFs. Alternatively, investors can follow the "Cash Subscription" route in which they can pay cash directly to the Fund for purchasing the underlying portfolio in creation units size.
ETFs have a very transparent portfolio holding and predefined creation basket. This allows arbitrageurs to create and redeem units every day through the in-kind creation / redemption mechanism. Such arbitrageurs are always in the market to take advantage of any significant premium or discount between the ETF market price and its NAV by doing arbitrage between the ETF and its underlying portfolio. Thus, the open architecture of ETFs ensures that there is no significant premium or discount to NAV. At the same time, additional demand / supply is absorbed due to the action of the arbitrageurs.
ETFs derive their liquidity first from trading of the units in the secondary market and secondly through the in-kind creation / redemption process with the fund in creation unit size.
Due to the unique in-kind creation / redemption process of ETFs, the liquidity of an ETF is actually the liquidity of the underlying shares.
While both are passively managed, the biggest difference is that Index Funds operate in the way all mutual funds do, in that they are priced at the close of the trading day based on the NAV of the underlying securities, whereas ETFs are priced to the market throughout the trading day. That means they are easier to buy and sell quickly, if need be. Secondly, ETFs are available only on stock exchanges. Hence, you need a demat account to invest in an ETF, whereas for an Index Fund, you don’t need a demat account and you may buy or sell the Units of an Index Fund directly from the mutual fund in small amounts.
Dividends received by an ETF are typically reinvested in the Fund.
Constituents of an index (i.e., the underlying stocks) may be changed as and when securities in the index do not match specific criteria laid down by the index service provider or a better candidate is available to replace a constituent. The index service provider usually makes announcements of change well in advance. Once securities in the underlying index are changed, the Fund can change the securities in its underlying portfolio by selling the securities that are being removed from the index and including those that are included in the index. This will in no way affect the units being held by an investor, as the units will continue to track the Index, the only effect may be on the tracking error of the scheme.
Tracking error is the difference between an ETF portfolio's returns and the benchmark or index it was meant to mimic or beat.
ETFs and Index funds, much like other mutual fund schemes, incur expenses on cost heads, such as marketing, advertising, office administration, brokerage and so on. These expenses reduce the ETF’s returns. The ETF may also receive dividend from the underlying stocks which may temporarily lead to the ETF out-performing the benchmark. This deviation in performance is nothing but the “tracking error” and is expressed in percentage terms. Tracking error is sometimes called active risk. How well an index fund manages its inflows and outflows also determines tracking error. The lower the tracking error, the better the ETF / Index fund.
ETFs combine the range of a diversified portfolio with the simplicity of trading a single stock. Investors can purchase ETF shares on margin, short sell shares, or hold for the long term. ETFs can be bought / sold easily like any other stock on the exchange through terminals across the country.
Asset Allocation: Managing asset allocation can be difficult for individual investors given the costs and assets required to achieve proper levels of diversification. ETFs provide investors with exposure to broad segments of the equity markets. They cover a range of style and size spectrums, enabling investors to build customized investment portfolios consistent with their financial needs, risk tolerance, and investment horizon. Both institutional and individual investors use ETFs to conveniently, efficiently, and cost effectively allocate their assets.
Investors typically seek exposure to equity markets, but often need time to make investment decisions. ETFs provide a "Parking Place" for cash that is designated for equity investment. Because ETFs are liquid, investors can participate in the market while deciding where to invest the funds for the longer-term, thus avoiding potential opportunity costs. Historically, investors have relied heavily on derivatives to achieve temporary exposure. However, derivatives are not always a practical solution. The large denomination of most derivative contracts can preclude investors, both institutional and individual, from using them to gain market exposure. In this case and in those where derivative use may be restricted, ETFs are a practical alternative.
ETFs are an excellent hedging vehicle because they can be borrowed and sold short. The smaller denominations in which ETFs trade relative to most derivative contracts provides a more accurate risk exposure match, particularly for small investment portfolios.
Arbitrage (cash vs futures) and covered option strategies:
ETFs can be used to arbitrage between the cash and futures market, as they are very easy to trade. ETFs can also be used for cover option strategies on the index.