Exchange-Traded Funds (ETFs)

by Mansi Singhal

An Exchange Traded Fund (ETF) can be defined as a financial instrument or a basket of securities that keeps the track of any sector, commodity, asset, or index, and can be brought or sold on a stock exchange i.e., National Stock Exchange or Bombay Stock Exchange just like a regular stock.

These popular funds, which are just similar to mutual funds but traded like stocks, have become a popular choice among both small and large investors which diversify their investment portfolios without consuming much time and effort of the investors which are generally required in another form of investment. The price of ETFs will change throughout the day, but unlike mutual funds, which are not traded on the stock exchange. ETFs are more cost-effective and liquid as compared to mutual funds.

Examples of ETFs in India

The list of best ETF to trade in India are :

  • HDFC Sensex ETF
  • SBI-ETF Sensex
  • Edelweiss ETF-NQ30
  • Reliance ETF Liquid BeES
  • UTI Sensex Exchange Traded Fund
  • Nippon ETF Bann

Before investing in EFT, it is important to take the following into account:

  1. Open a trading account with a broker / sub-broker.
  2. Must hold a Demat account for holding the EFTs units.

Types of ETFs

There are several types of ETFs available to investors based upon multiple factors like income generation, amount of investment, and risk in the investor’s portfolio. Below mentioned are some examples of EFTs-

  • Bond ETFs:

Bond EFT exclusively in bonds. They are similar to bond mutual funds because they hold a portfolio of bonds with different strategies. It will include government bonds (State and Local Bonds), corporate bonds, municipal bonds.

  • Industry ETFs:

Industry EFT is a pooled investment fund vehicle that will track a particular industry such as banking, technology, healthcare, textile, sugar, etc. The international market industry may vary from one market to another market based on geographical and economic conditions.

  • Commodity ETFs:

Commodity EFT will basically invest in different commodities such as crude oil, gas, gold, silver, etc. It has been observed that in initial phase beginners avoid commodity ETFs and attract to other ETFs because they considered it as a volitale form of an investement.

  • Currency ETFs:

Currency ETFs mainly profit due to the fluctuation in the exchange rates of currency. It will invest in foreign currency such as the dollar, dinar, euro, etc. In this ETF, profit rate may be much as compared to other types of ETF but it contains some percentage of risk due to currency prices of any country are highly dominating due to both internal as well as an external factor.

  • Inverse ETFs:

Using different derivates, Inverse ETFs are able to generate profit from a decline in the value of an underlying benchmark. These ETFs will allow the investors to make money when declines, without selling anything in a short period of time.

ETFs Schemes

Some most popular scheme of ETF are as follows:-

  • Index ETF:

Index ETF mainly tracks a particular market index like Sensex, Nifty, BSE 100, Nifty 100, etc. Investors should expect to get the index returns which their ETF is tracking, which is not more, not less.

  • Gold ETF:

Investors can buy gold as a financial asset in the form of a Gold ETF which can be a substitute for physical gold and can be an exchange-traded fund that aims to track the price of the gold in the market, which is also traded on the stock exchange.

  • Bank ETF:

It contains the banking stock listed on the stock exchanges. It attract the both small as well as big investors because there are a lot of shares in this list.

  • International ETF:

An International ETF only invests in foreign-based assets and securities and tracks the global market. It can be a good investment, but risk consideration is much higher as compared to other schemes. Institutional investors are mainly meant for this type of investment because their motive is to earn profit in the long run who has the potential to bear the risk in the market.

  • Liquid ETF:

Liquid ETFs are totally different from the International ETF. Under this scheme, investment is made in a basket of short-term government securities, call money, money market, currency derivatives which are highly liquid.

Uses of ETFs

  • Asset Allocation: ETFs provide the investor’s exposure to broad their equity segments by covering a range of style and size spectrums and enable them to build customized investment portfolios with their financial needs, risk tolerance, and investment horizon. Both large and small investors use ETFs to conveniently, efficiently allocate their assets.
  • Cash Equitisation: ETFs are liquid in nature, so allow the investor to participate in the market by ensuring them where to invest the funds for long them, thus neglecting the opportunity cost. ETFs provide “Parking Places” for cash that is designated for equity investment.
  • Hedging Risks: ETFs are proven to be an excellent hedging vehicle for portfolio managers because they can be borrowed and sold in a shorter time period. The small denominations relate to most of the derivative contract that provides a more accurate risk exposure match, mainly for a small portfolio.
  • Arbitrage and Covered Option Strategies: ETFs can be used to arbitrage between the cash and futures market and can also be used for cover options strategies on the index.

How to select ETFs and Index Funds?

Mainly there are three parameters which investors should considered while thinking to invest in ETFs:-

1. Total Expense Ratio: Low risk (arbitrage means risk-free profits)

2. Tracking error: Tracking error means the deviation between index return and ETF return. It is not that much easy to identify the error at the initial stage of the investing but considered as the most important parameter because investors are actually investing in the index.

3. Liquidity: Liquidity is an important factor for ETFs because ETFs are brought and sold in the stock exchange. If an ETF is not liquid, investors will find difficulty in selling that particular form of ETF.

How to Buy and Sell ETFs?

ETFs are traded by both online brokers as well as traditional brokers dealers. You have to identify the best broker who has a piece of absolute knowledge about the market, which not only eases your trading but also increases the value of your investment. One can invest in the ETF by-

  • Buying and Selling of ETF through a broker by telephonic mode or by placing an online order on an online trading terminal provided by their respective broker. Through the Security & Exchange Board of India, you may check whether the broker is registered.
  • You can place your ETF order by calling your broker and inform him about your specifications.
  • You can also place your order through an online trading terminal. These terminals are similar to buying and selling of shares on the exchange through the terminal.

How much ETFs cost?

ETFs include some costs like commission cost and operating expenses incurred while holding the ETFs which make it expensive. While the trading cost can also include two hidden costs which are bid/ask spreads and change in discounts and premium. The total cost of owning an ETF may vary, and depends upon the asset class of the investment fund as well as the investor’s portfolio strategy.

How do ETFs work?

ETF contains some characteristics of both the shares and the mutual funds. They are traded in the stock market in the form of shares. ETF funds are listed on all the major stock exchanges which can be brought and sold as per the investor’s requiement. Underlying assets which are present in the pool of resources will directly impact the share price of EFT from time to time. If the price of any particular asset rises, the share price of ETF will also rise accordingly, and vice-versa.

Whereas, the dividend received by the shareholder will depend upon the performance and asset management of the concerned company deals in the ETF and actively or passively managed according to the company norms. Actively managed ETFs are operated by the portfolio manager, after analyzing the stock market conditions and calculating the risk incurred during the investment in the companies. On the other hand, passively managed ETFs will follow the trends of the specific market and only invest in the rising companies.

Advantages of ETFs

ETF contains some characteristics of both the shares and the mutual funds. ETFs are also traded on the stock exchange just like other stocks. ETF funds are listed on all the major stock exchanges and can be brought and sold as per the investor’s requirement during the trading time. There are several advantages of ETFs, especially when compared to another form of investment such as:

#1 Lower Costs

As ETFs are traded like the stock in the market, but the main important thing to be considered that one can buy a diversified portfolio at a lower commission as compared to stock. Although, ETFs incurred lower expense ratios than mutual funds.

#2 Diversification

There are hundreds of ETFs traded all across the globe. It will cover all major sectors (insurance, healthcare, pharmaceutical, etc.), industries (large-cap, mid-cap, small-cap), market (developed, developing, underdeveloped) and even commodities, leverage funds, Bond ETF ( long, mid, short, etc.) and also region based fund

# 3 Transparency

Most of the ETFs track an index and this would mean passive management for the fund house to maintain the ETF portfolio. This makes it easier for the investor to know the performance of ETF.

# 4 Immediately Reinvested Dividends

The dividends of several companies in an open-ended ETF are reinvested immediately. The exact time for reinvestment can vary for index mutual funds.

# 5 Lower Discount

There is a very lesser chance of ETF share prices being higher or lower than their actual price. ETFs are traded throughout the day at a price close to the price of the underlying asset. If the price is significantly higher or lower than the net asset value, arbitrage will bring back its price to normal.

ETFs are also traded on supply and demand, and price-makers will capture the price discrepancy.

Disadvantages of ETFs

With numerous advantages over the mutual fund and stock, ETFs carry drawback also such as:

#1 Over Diversification

For some sectors, investors might be concise to the large-cap stocks only due to the narrow group of the equities in the market index. A lack of exposure to the mid-cap and small-cap companies could leave potential growth opportunities for ETF investors. As ETFs are generally not actively managed but are programmed to follow a specific index. It may be more advantageous to buy a limited number of the high-growth companies rather than their own entire index.

#2 Lack of Rebalancing

Sometimes investors don’t rebalance their investment portfolio. In an index, if the winner increases the price they become a large percentage of an index, and also if some stocks decline in the prices and become a smaller percentage of an index.

#3 The cost could be higher

Most people compare the trading of ETFs with the trading of funds, but if you compare the ETFs to investing in a specific stock, the cost must be much higher, The commission paid to the broker may be the same, but there is no management fee for a stock.

#4 Buying high and selling low

ETFs contain two prices, a bid, and an ask. Investors should be aware of a spread between the price they will pay for shares say ask price and the price a share could be sold say bid price. It also helps to know the intraday value of the fund when the investor is ready to execute the trade.

#5 Tracking error

ETF portfolio managers are supposed to keep the fund investment performance in line with the index they track but it is not that much easy and it will be a cost to the investors.

ETFs V/S Mutual Funds

ETFsMutual Funds
Exchange Traded Funds are traded during the course of a trading day and their value may vary during the trading time.Mutual funds are traded at the closing net asset value.
Mutual funds are traded at the closing net asset value.Mutual Fund have varying operating expenses.
No minimum investment required in the ETF.Mutual Funds have a minimum expense specified.
ETF can be brought and sold anytime on the stock exchange just like the stocks.Mutual Funds shares can only be purchased directly from the funds at a Net Asset Value price that is fixed during the trading day.
ETF has higher liquidity as compared to mutual funds.Mutual Funds have lower liquidity.
ETF does not have any limit on selling an asset, investors can buy or sell at any point of the trading day at a price previous in the market.Some mutual find levy a penalty on selling the share early, Basically, the time limit imposed on selling a share is 90 days from its purchase dates.

Conclusion

Though Indian ETFs are still at an emerging stage and new to the people, they are expected to replicate some of the asset classes that are offered globally, with gold ETFs are likely to be the leader of the whole ETFs basket.

Recent launches such as Most Shares NASDAQ 100, Goldman Sachs Hang Seng BeES offer differentiated products that attract choices across asset classes, investment styles, risk capability, and geographies. Because of the versatility, liquidity, and low trading cost that ETFs offer, they are an increasing and emerging investment option. Investors urged to explore the large, varied offerings of ETFs and considers ETFs investment as an ideal option in their investment portfolio.

FAQ’s

1. Are ETFs a good investment?

ETFs have become incredibly popular investments for both active and passive investors over a period of time. Although ETFs provide low-cost access to a variety of asset class, security, sectors, markets which do not carry any risk and ETFs are highly liquid as compared to another form of investment. So, ETFs are considered a good investment.

2. How do ETFs work?

An electronic funds transfer moves money from one account to another electronically over a computerized network. EFTs require both the sender and recipient to have bank accounts in any bank. . The accounts do not have to be at the same financial institution to transfer funds. Demat account is compulsory to hold ETF stock.

3. Are ETFs good for beginners?

Yes, ETFs are an ideal investment for beginners because one can avail them at low operating expenses such as brokerage commission, bid price, spread price, as compared to mutual funds or stock and also it has more option such as range of an investment, diversification option, liquid nature of stock, easy accessibility which made it better than other investments options.

4. Are ETFs better than stock?

ETFs have an advantage over stock as they are highly liquid and secondly if you are unable to gain an advantage through knowledge of the company, an ETF is your best choice.

5. Do ETFs pay dividends?

There are 2 basic types of dividends issued to investors of ETFs: qualified and non-qualified dividends. If you own shares of an exchange-traded fund (ETF), you may receive distributions in the form of dividends. These may be paid monthly or at some other interval, depending on the ETF.

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