All about Exchange Traded Funds

Exchange Traded Funds or ETF are very famous nowadays. ETF is a recommended investment instrument as a part of your financial planning portfolio thus most of the investors have heard the term. Here I am giving a minimal but most required introduction to this instruments that each investor should know. I am also giving you the advantages and disadvantages of ETF for your better awareness.

As the name shows, an exchange traded fund unit is a bundle of stocks that an investor can buy directly from stock exchange like buying any other stocks or shares. Comparing with mutual funds, when you investing to the ETF, you are diversifying your money to the entire stocks inside a particular group, generally called an Index. Where, mutual funds also following the same path but, investing in a group of carefully selected stocks instead of all the stocks in an index.

ETF by nature track a certain index. For an example, a large cap index focused ETF unit comprises all the stocks that are coming under the large cap index of the stock exchange. For better awareness, suppose an ETF that is tracking the large cap index of a stock exchange comprising 50 eminent companies in the nation and if you are buying a unit of this ETF by paying 50$, or Rs.50, you are getting the investment exposure in each stocks in that large cap index. In this case, you have Rs.50 or $50 invested equally in each 50 stocks of the existing large cap index. That mean, you have invested $1 or Rs.1 on each company in the large cap index.

Generally the ETF price calculation directly depends on the index points. If the large cap index is 4500 presently, the price of a single ETF will be 450. It will high or law as per the fluctuation of the index which is tracking by this ETF.

There are other ETF also available in the market. For example: Gold ETF. With gold ETF the price determination of a unit will be same to the price of 1 gram physical gold. You can see midcap ETF, sector ETF like Banking ETF etc.. all are very popular nowadays.

Let us now look at how similar and dissimilar the ETFs are vis-à-vis the conventional MFs.

1. Since all ETFs require certain specific shares to be deposited for units to be created, they all are usually index-specific like Nifty, Sensex, Bankex etc. As against this, a conventional mutual fund can have any portfolio (though as per the pre-defined objective). Of course index funds will also mimic the index and hence to that extent ETFs and index funds are same

2. Because ETFs are index-specific, the portfolio remains more or less constant, whereas portfolio of an actively managed conventional MF will change on day-to-day basis. Hence, while portfolio of ETF is known beforehand, the portfolio of a conventional MF can be known only at the time of month-end disclosures.

3. ETFs are bought/sold on the stock exchange and need a demat account. Conventional MFs are bought/sold from/to the AMC.

4. ETFs can be traded like a stock at any time of the day and at real-time prices, while the market is open. Whereas, one can buy MFs only at the NAV based on the closing prices.

5. The unit capital of close-ended funds (and even shares) will not change with trading. But unit capital of ETF can change with trading and hence to that extent they behave like open-ended funds

6. There are some close-ended funds listed on the exchange. But because they are structurally different from an ETF, they can trade at substantial discount (or premium) to the NAV. This will not be the case with ETFs.

7. Like conventional MFs, they offer the benefits of diversification

8. As financial instruments per se, ETFs are as safe as conventional MFs. But, of course, the market risk remains.

9. In ETF, AMCs need not keep a large portion in cash to meet redemption pressures

10. Also, unless there is a huge redemption pressure, shares need not be sold to generate cash to meet the redemptions – the normal buying and selling of units amongst the investors will take care of day-to-day redemptions. To that extent, ETFs are somewhat protected

11. In ETF each investor pays his share of costs, unlike conventional MFs where costs are deducted from the NAV on an average basis. As such the long-term investors suffer, while short-term investors end-up paying lesser costs in conventional MFs.

There are benefits to invest in ETF. The major benefit is it is less volatile and the high diversification between multiple companies coming from various sectors. This will give security to your money in a great extent. Below are the major advantages and disadvantages of ETF.

Benefits of investing in ETFs

• Convenient to trade as it can be bought/sold on the stock exchange at any time of the day when the market is open (index funds can be bought only at NAV based on closing prices)

• One can short sell an ETF or buy on margin or even purchase one unit, which is not possible with index-funds/conventional MFs

• ETFs are passively managed, have low distribution costs and minimal administrative charges. Hence most ETFs have lower expense ratios than conventional MFs

• Not dependent on the fund manager

• Like an index fund, they are very transparent

Disadvantages of investing in ETFs

• SIP in ETF is not convenient as you have to place a fresh order every month

• Also SIP may prove expensive as compared to a no-load, low-expense index funds as you have to pay brokerage every time you buy and sell

• Because ETFs are conveniently tradable, people tend to trade more in ETFs as compared to conventional funds. This unnecessarily pushes up the costs.

• You can’t automatically re-invest your dividends. Secondly, you may have to pay brokerage to reinvest dividends in ETF, whereas dividend reinvestment in MFs is automatic and with no entry-load

• Comparatively lower liquidity as the market has still not caught up on the concept

Hope you have got the best idea about Exchange Traded Funds. In my personal opinion, investing in ETF is a better method to get long term handsome returns with defensive investment strategy. Have a taste.Comment frequently if you feel that I had missed something important in this article. I will certainly have a look and add the points at the earliest.