ETF is short for Exchange Traded Fund. It uses the same idea behind index funds which track a particular index.

When you invest in ETFs, your money is invested in a bunch of market securities which are part of a pre-determined index. The investment is made in the same proportion as the index. However, unlike index funds or other mutual funds, ETFs are traded on the stock exchange, and they experience price changes throughout the day whereas mutual funds are valued once in a day. These changes in the price are dependent on the demand and supply of the ETFs. The country’s first ETF, Nifty BEES tracks the S&P CNX Nifty Index while ICICI Prudential’s SPiCE tracks the BSE Sensex. These two are just examples of the ETFs available in the market for investment.

Just like the name says, ETFs are exchange-traded which means that you can buy and sell them any time of the day when the markets are open. The same way you buy shares in a stock, you can buy ETFs and time their purchase and sale to profit from the transaction.

History of ETFs

ETFs came into existence in 1989 when Index Participation Shares which is an S&P 500 Proxy was traded on the American Stock Exchange and Philadelphia Stock Exchange. The success of the product led to the launch of a similar product in Tokyo Stock Exchange the following year. They gained momentum quickly and reached over $882 billion spread by the end of 2010. While they started with tracking market indices, today, ETFs track bonds, commodities, currencies, and sectors in addition to market indices.

Types of ETFs Available for Investment

Gold ETF – If you wanted to invest in gold without having to worry about buying physical gold and storing it safely, then gold ETFs are your answer. A Gold ETF tracks the price of gold. Every unit represents the price of gold and they are traded on the exchange just like stocks. It is an easy way of investing in gold without worrying about its safekeeping. SBI Gold ETF, UTI Gold ETF and Kotak Gold ETF are examples of gold ETFs available in India.

Index ETF – Index ETFs track a market index. This is where ETFs had originated from. The index works as a tracking instrument and the ETFs track the performance of the index by holding shares in its portfolio in the same proportion as the index. SBI ETF BSE 100 is an ETF that mimics the BES index.

International ETF – International ETFs generally give an investor an idea of the economic standing of the country. They track the major market index in the country. NASDAQ and HANG SENG are two examples of tracking instruments for international ETFs. An example of such an ETF is the GS Hang Seng BeES issued by Goldman Sachs Asset management which tracks the Hang Seng index.

Sector Specific ETF – Investors who want to invest in a specific sector will be interested in the Sector Specific ETFs. These use the performance of a sector as a tracking instrument. Depending on the sector you choose to invest, you will see the value of the ETFs go up or down based on the performance of the sector. Columbia India Infrastructure ETF follows India Infrastructure Index which is based in the infrastructure sector of the country.

ETFs have lower expenses

One thing that comes up every time we discuss ETF with anyone is the fact that they are relatively cheaper. They cost less than index funds because ETFs do not rely a lot on marketing and distribution. Most of the times, the trade takes place with other investors, so ETFs do not always involve the fund company. This makes the trade smoother for everyone. But ETFs involve a brokerage that you end up paying your broker every time you buy or sell them. So they end up with an entry and exit cost for you.

While the SBI ETF Nifty 50 is an ETF with an expense ratio of 0.07%, the UTI Nifty Index Fund has an expense ratio of 0.21%. While you may be able to save on the expense ratio when investing in an ETF, you will end up paying brokerage. If we assume a brokerage of 0.50% for buying and selling, then 1% is added to the costs for trading ETFs as well. Mutual funds, on the other hand, have higher expense ratios given the fact that they are actively managed funds.

The real time price of the ETFs is based on the demand and supply at the exchange. If there are more buyers than sellers then the price of the ETF will rise and the price falls when there are more sellers than buyers. ETF providers (fund houses) usually display the real time price which is also known as iNav on their website.

What are the risks involved in an ETF?

ETFs are comparatively less risky than trading in shares but there are a few things that you must be aware of.

  • A primary risk with ETF is that of liquidity. The buying and selling prices of this financial instrument can differ greatly.
  • Another problem is that the Indian investment market is yet to explore the complete potential of ETFs. The market is not very mature for ETF investments of various kinds. With limited options, ETFs are often not considered to be the choice investment for many investors.
  • It requires you to interact with a broker and maintain a Demat account.
  • Most of the times, it also requires you to time the market so that you can enjoy substantial profits. Since an ETF mimics an index, you have to be careful about market changes. If the market goes up then you get to enjoy the profit, but if it goes down, then you will end up in a loss which will not provide any consolation no matter how cheap the ETF was.
  • Tracking error which appears in funds that track an index can also become a risk for an ETF. If you find that the tracking error to be very high, then these funds will carry a higher risk. This is because some fund managers buy only some of the stocks and bonds in an index which may cause the ETF to overperform or underperform.

How Do You Select The Right ETF?

We often hear that expense ratio makes a huge difference when you choose a fund, but the truth is that there is a lot more to buying a fund than the expense ratio. It is important that you look beyond expense ratio to find out if the fund will be suitable for your portfolio or not.

Identify The Index It Is Tracking

The best place, to begin with, is by identifying the benchmark for the ETF you wish to buy. If you find a few ETFs that are suitable according to their benchmark, then you must proceed into digging a little deeper so that you can find what indices they are tracking. Direction Daily MSCI India Bull 3x ETF (INDL) uses the MSCI India Index as its benchmark and aims to grow the fund at three times the rate of the index. It invests 80% of the assets in securities of the index while 20% is invested in other financial instruments. This adds a higher level of risk but it also improves the returns on the funds.

Ensure That The Asset Allocation Matches Your Financial Goals

Do the indices match the asset allocation you have in mind? Check the breakdown to find out if it makes enough sense. Check how the stocks and bonds are weighted in the ETF. Find out if the weightage is what you would want for your portfolio. For example, Columbia India Infrastructure ETF (INXX) is best for people who would like to invest in infrastructure in India while Columbia India Small Cap ETF (SCIN) is more suitable for those who wish to invest in a basket of stocks listed on the MVISA India Small Cap Index.

Check For Tracking Error

Once you have identified the ETFs that fulfill your portfolio requirement, then the next thing to look out for is the tracking error. Check the difference in the tracking instrument and the ETF to find out it if you will be investing in ETFs that are riskier. In India, most of the popular ETFs do not completely track an index, instead, they invest part of the assets in the index while the rest is used for investing in other financial instruments. This is done to increase returns so you will find the tracking error to be high in most of the ETFs you invest in.

Look For Liquidity in the ETFs You Invest In

The liquidity of the ETF is another factor that will determine the profitability of your investment. Look for an ETF that provides adequate liquidity. There are two factors that play a role in the liquidity of the ETF – the liquidity of the fund itself and the liquidity of the shares that are being tracked.

What are the advantages of ETF?

Cost Effective– ETFs are known to be very cost effective when compared to other funds. This is because there isn’t a lot of management or cost involved in the transactions. They are economical for a small investor and they are known to be cheaper to maintain over a long period of time.

Simple – ETFs aim at simplicity. They are very transparent in nature and they have a very simple structure. Unlike other mutual funds which are managed actively by a fund manager who decides where the funds are allocated, ETFs are meant to emulate a particular index, commodity or currency which makes it easier for the investor to understand how his funds are being allocated. It also helps them ensure that they are investing in a fund that meets their asset allocation requirements.

Diversification – By mimicking an index, ETFs provide diversification in the investment. Just one trade will help you gain a basket of securities or assets. There is no better way to reduce risks that to diversify your funds. With ETFs your job is made easier since it automatically diversifies the funds.

Passively Managed–While ETFs need to be managed just like any other fund, they do not require active management by a fund manager. They aim at tracking the index without trying to outperform it. This means that the ETFs simply need to be invested in the same proportion as the stocks in the index. There are no aggressive strategies that come to play when you invest in ETFs. This keeps the costs on the lower side and it also ensures that the chances of risks are reduced to the performance of the index and not the fund manager.

Comparison of Mutual funds, Index funds, and ETFs

Mutual Funds Index Funds ETFs
Priced once a day Priced once a day Priced throughout the day
Sold by fund companies Sold by fund companies Traded through stockbrokers
Higher expense ratio, no cost to trade Lower expense ratio than active mutual funds, no cost to trade Lowest expense ratio, but includes brokerage for trading.
Easy to sell Simple redemption process Trading depends on liquidity of the ETF
Actively managed funds Passively managed funds Passively managed funds