Exchange Traded Funds

Stepping into financial markets can be challenging for new investors as well as those not accustomed to its functioning. Worry about losing invested capital keeps some investors at bay. Those who do get attracted to markets worry about the prospect of underwhelming returns. Choosing the right instrument to invest becomes crucial to achieving one’s financial goals. A conversation with an expert will reveal that in order to grow wealth owning equities is imperative.

An investor can make stocks a part of his portfolio in three broad ways: investing in them directly, buying an equity-oriented mutual fund, or investing in exchange-traded funds.

What are ETFs?

Exchange Traded Funds, or ETFs in short, have been gaining popularity among investors as investment vehicles over the past few years. In addition to mutual funds, they have emerged as an instrument of choice when building a portfolio.

ETFs had a few hiccups when they were launched, but finally saw the light of day in 1993 in the US. According to the latest data available, investment in these vehicles stands at over $3 trillion in the US alone and a shade under $5 trillion globally.

In terms of structure and basic functioning, they are not unlike mutual funds. They are primarily a basket of securities which is spread across assets via an investment pool. This pool is formed by contributing investors who have issued shares as proof of their contribution. While buying a stock for a particular sum gives investors access to that stock alone, buying a share in an ETF allows them to spread their investment across stocks of several companies or other asset classes like bonds and commodities.

The concept of an ETF is based on passive investing. An ETF is structured based on a certain underlying index. It tries to mimic this index and its value changes based on the changes in this index. The portfolio of an ETF comprises of the same securities in the same proportion as that of the index. This composition changes only when the underlying index is rebalanced. Rebalancing is at the discretion of the index creator and can be quarterly, half yearly, or yearly.

As can be seen from above, an ETF goes in the direction its index goes in. Therefore, while selecting an ETF to invest in, one needs to look at the benchmark index. The index can be public or private; it may even have been created specifically for investment purposes as well.

Key features on ETFs

The key feature of ETFs is that they are listed on stock exchanges. Due to this, they can be bought and sold like stocks. Also, their price changes throughout the day. Like mutual funds, an end-of-day Net Asset Value (NAV) is also calculated. Lastly, there is no cap on creating additional shares of an ETF.

ETFs are also quite transparent in nature. They disclose their portfolio regularly which keeps investors informed about where their money is invested. Investors can not only get to know the stock level constitution of their ETF, but they can also get to know the sectoral, industry and geographic (in case of overseas funds) break-up as well.

Performance comparison is also easy as ETFs price data is available throughout the trading day. The fund provider also provides information on returns of ETFs across several periods and in comparison with its benchmark index as well. Investors benefit from ETFs in the form of capital appreciation in the fund as well as dividend distributions (at the discretion of the fund provider).

In terms of performance evaluation of ETFs, there is a metric which is followed more closely than absolute returns. The metric is tracking error. It tracks the difference between the returns of the fund and that of the underlying benchmark. Since ETFs are mostly passive in construction, tracking error is a more relevant measure of performance as it reflects the efficiency of the fund. The lower the tracking error, the better the fund has been able to replicate the index’s performance. Thus, between two funds with the same benchmark index, investors should look for a fund with a lower tracking error in order to reap the most benefits.

It is important to note that the tracking error of an ETF cannot be zero as there are costs involved in managing the fund which ensures that the performance of a fund will always be lower than its index.

How are ETFs created?

ETFs are created with the help of institutional investors known as authorized participants. Without their presence, an ETF cannot be created or redeemed. These investors have a large capital base which allows them to form a portfolio of securities. A strong financial position is required because these participants need to buy the stocks forming an index in the same proportion as the index. Once they buy all the stocks in the required proportion, they hand this over to the fund company which will sell the ETF and receives equivalent shares in return. These shares are in a block of 50,000 units and are known as creation units. Redemptions also take place in similar-sized creation units.

As far as the structure of ETFs is concerned, it can be that of a corporation or a trust. This structure is determined by the regulation set by the country of domicile of the fund. Some countries allow only an investment company structure for ETFs while others mandate them to be trusted. Investors who buy the ETF are issued shares as proof of their ownership. By owning these shares, they become indirect owners of the underlying assets.

Because of their scale of operation and ownership, these authorized participants can play a major role in aligning the price of an ETF and its underlying assets. They can make use of the arbitrage mechanism to align these prices due to their ability to buy and sell creation units.

Chief advantages of ETFs

A big draw for investors contemplating ETFs as investment options are the low fee charged by these funds. In terms of the expense ratio, they are usually cheaper than mutual funds because an investment team, led by a fund manager, which is required for mutual funds, is not required for ETFs.

A fund manager and his team of analysts need to create the portfolio of a mutual fund according to its investment objectives, monitor it to ensure that it continues to fulfill those objectives according to the prescribed guidelines and make changes to the composition if a better opportunity comes around. For performing these functions, this team charges a management fee which becomes a part of the expense ratio and increases it. This setup is not required in ETFs as they are designed to just replicate an index, not outperform it.

Another advantage of ETFs is that since they are listed on stock exchanges, investors can buy and sell them throughout a trading day. This is a significant advantage over mutual funds for which though investors can place a trade order anytime during the day, it is executed only once based on the cutoff timing of the category of the fund they are trading.

Because ETFs are traded only on exchanges, they have high liquidity as well. In case an investor wishes to sell all or part of his holding because of an urgent need for funds, he can do so easily in ETFs. The settlement is also quicker in ETFs than in other fund structures.

Though they trade are like individual stocks, they are better in the sense that unlike stocks the number of outstanding shares of an ETF can change because of the continuous creation of new shares and the redemption of existing shares. This ability to increase or decrease the number of outstanding shares also helps in keeping their prices in line with the underlying asset value.

ETFs also offer tax efficiency, especially when compared to a mutual fund. In the latter, for every purchase or redemption, a fund manager needs to buy or sell shares which can trigger a tax liability. Meanwhile, since most trades in ETFs occur on exchanges, the trade takes place between two investors and no buying or selling of underlying securities is required.

Disadvantages of ETFs

Since ETFs are available only on exchanges, investors need a demat and trading account to trade in them. Thus, those without the aforesaid facility cannot invest in ETFs.

A small size ETF can be disadvantageous because it may be unable to mirror an index closely, thus resulting in a large tracking error. During declining markets, their small size may lead to liquidity issues as well. Also, if the underlying securities in an index are less liquid, it can also increase the tracking error which would result in investors not getting the optimum returns from their investment.

Even though the expense ratio of ETFs is usually less than that of a mutual fund, they can turn out to be a costly affair if an investor trades frequently. Since they are traded on exchanges, fee-related to that is applicable to each transaction. So, the more frequent the trades, the higher the overall cost of investing and holding the fund.

Types of ETFs available in India

Globally, ETFs offer various kinds of products including actively managed ETFs. One can get access to fixed income, currency, and commodity asset classes via these funds. In India, ETFs offer access to the following asset classes: Equity, Debt, Gold, and International. Gold ETFs follow equity ETFs in terms of popularity in the country. The following list presents examples of some ETFs available in India in these four categories (this is only an indicative list):

Equity:

HDFC Sensex ETF

Reliance ETF Nifty BeES

ICICI Prudential Midcap Select ETF

Edelweiss ETF – Nifty Bank

LIC MF ETF – Nifty 100

Debt

LIC Nomura MF G-Sec Long Term ETF

Reliance ETF Long Term Gilt

SBI-ETF 10 Year Gilt

Gold:

Axis Gold ETF

Canara Robeco Gold ETF

Quantum Gold Fund

International

Motilal Oswal NASDAQ 100 ETF

Reliance ETF Hang Seng BeES

There are ETFs like the Bharat 22 ETF which have a unique index created specifically for its purpose: the S&P BSE Bharat 22 Index.

India is still at an early stage of ETF investing. But given the advantages the product offers, it is likely that more innovative funds will be launched in the future as investor interest heightens.
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