ETF stands for exchange traded funds.
These are instruments that invest in stocks or securities in the same proportion as the index that they track. We can say that each ETF tracks a particular index, which can be related to equity, debt or gold indices.
As they track a particular index, they are a popular instrument for passive investors as these kinds of investors have less time to follow the market. However, as they want to participate in the markets, they can invest via an ETF.
Apart from the features mentioned above, there are two key attributes related to ETFs which we must be aware of:-
- ETFs closely match the returns of the securities represented in the index;
- Another important feature is that ETFs trade on exchanges. Therefore, it gives us the ease to buy or sell them anytime.
Even when it comes to liquidity, it is very high for ETFs and at the same time they charge lower fees.
Now that we are clear about what an ETF is, let us understand this in detail. We have divided this article into various sub-headings. The ultimate aim is that an investor is well versed with ETFs after reading this article.
In this article
- Types of ETFs
- ETFs vs Mutual Funds
- Investing in ETFs
- Creation and Redemption of ETF
- Key Advantages of ETFs
- Disadvantages of ETFs
- Tax Applicable in Case of ETFs
- Most Actively Traded ETFs in India
Types of ETFs
Some broader types of ETFs are discussed below:-
In this type of ETFs, all the stocks that are present in the index are bought. The example following the Nifty index will induce buying of all the Nifty 50 stocks.
These types of ETFs invest in fixed income instruments such as central government bonds, state government bonds, corporate bonds, bonds issued by various financial institutions, treasury bills etc.;
As the name suggests, commodity ETFs invest in commodities such as oil, gold etc.
These types of ETFs invest in the stocks of a particular industry or sectors such as financials, FMCG, IT etc.
They use the performance of a sector as a tracking instrument. Depending on the sector that we choose to invest, we will see the value of the fund increase or decrease as per the performance of the fund.
Some other types of ETFs include foreign market ETFs that track the index of foreign markets such as NASDAQ, S&P 500 index, Japan’s Nikkei Index etc. There are also ETFs termed as style ETFs that are designed in such a way as to track a particular investment style or is focused on market capitalization such as large-cap, mid-cap or small cap.
ETFs vs Mutual Funds
Let us now reflect on the differences between ETFs vis-à-vis mutual funds.
In its very essence, ETFs trade like stocks and therefore provide a greater degree of flexibility and ease unlike that of mutual funds.
In case of mutual funds, investors can purchase units only at the fund’s NAV, which is published at the end of each trading day. However, investors cannot purchase ETFs at the closing NAV.
Therefore, this is advantageous when it comes to broader sense of the markets as the risk of price differential (price at the time of investment vs. the time of trade) is substantially lower in case of ETFs.
Another important thing to note here is that traditional mutual funds have higher fees as compared to ETFs. Though there are fees in case of ETFs, such as fees paid as commission to brokers or in case of redemption whereby a low expense ratio is charged, but this is significantly lower when it comes to mutual funds.
ETFs also have a low tracking error and lower fees as compared to index funds. (Note: Low tracking error means the fund’s portfolio closely follows the benchmark index. While the expense ratio for index funds is in the range of 1 percent, there are various ETF schemes that charge less than 0.1 percent)
Some other key differences between ETFs and mutual funds are highlighted in the table below:
|Parameter||Open-ended mutual funds||Exchange Traded Funds (ETFs)|
|NAV Publication||NAV is published daily||NAV is published on a real time basis|
|Portfolio Disclosure||Portfolio changes are reflected in the factsheet that is published monthly||It is reflected on a real time basis/ daily|
|Sale Price||Sale price is at the NAV plus the load||The sale price is very close to the actual NAV of the scheme|
|Intra-day trading||Intra-day trading is not possible in case of mutual funds||Intra-day trading is possible at low costs|
Investing in ETFs
There are two ways in which an ETF can be bought and sold. But there are two essential prerequisites to start investing in ETF, which are:
- You need to open a trading account with a broker / sub-broker;
- You need to have a demat account for holding the ETF units
Once you have these two things, you can buy or sell the ETF units through the broker. This can be done through the telephonic medium or through the online trading terminal.
Various costs that are involved while purchasing an ETF are:
- Brokerage commission when purchasing/ selling ETFs;
- Usual cost of trading stocks, such as the bid-ask spread;
Creation and Redemption of ETF
Creation and redemption is the key to understanding ETFs. It is the mechanism through which ETFs gain exposure to the markets because of which they become less expensive and more transparent.
While dealing with ETFs, the asset management companies take the shares of companies comprising the index from various categories of investors. These can be large investors, authorized participants and institutions. In return, the asset management company issues them a large block of ETF units.
There is also an element of ‘Cash Component’ as dividends may have accumulated for the stocks at any point in time. Therefore, a large block of ETF units called a ‘Creation Unit’ is exchanged for a ‘Portfolio Deposit’ of stocks and ‘Cash Component’.
ETFs generally trade close to their fair value at any given time.
Let us understand how this takes place. To give it a head start, the number of outstanding ETFs is not limited as with traditional mutual funds. It may increase if investors deposit shares which thereby increases the number of ETF units.
Conversely, it may reduce on a day if some ETF holders redeem the ETF units. These types of transactions are conducted by sending creation and redemption instructions to the fund. The ‘Portfolio Deposit’ monitors the amount of stocks in the index as well as the ‘Cash Component’.
Hence, an in-kind creation/redemption facility is set up which ensures that ETFs trade close to their fair value at any point in time.
Key Advantages of ETFs
Let us delve into the advantages and disadvantages that are in store when we consider investing in ETFs. First, let’s look at the advantages
1.Benefit of Diversification
ETFs help you spread your investment risk over a number of securities and hence reduce the stock specific risk. Investing in ETFs can be considered as a hedging strategy if you are an active stock investor.
You also have the option of not just diversifying your investment in stocks, but also take commodity exposure, sector-specific ETF and even country (index) specific exposure;
As the performance of an ETF is dependent on an index and is therefore totally a passive form of investment. This provides us the ease to know the performance of the ETF easily;
3. Lower Transaction Cost:
As discussed, the costs involved in investing via ETF is much lower than other index based products, as well as mutual funds.
Therefore, investors who want to participate in the growing market but are unsure of the investments to be made can invest in various types of ETFs for the long term.
4. Ease of Investing/ Convenience
You can look at the trading portal and can transact in ETFs.
As ETFs are listed on exchanges and are well regulated, as investors you can be rest assured about the product you are putting our money in.
Also, you are free from continuously monitoring the performance of your investment which is in the case with mutual funds and shares as well.
You just need to remember that your returns will be market linked in case of ETFs.
This benefits fund manager that trade or invest in ETFs. As fund managers need constant inflow and outflow of cash, ETFs as liquid instruments can help fund managers for portfolio management purposes;
6.Opportunities of Arbitrage
This benefit is for traders and not for long term investors. As ETFs are index tracking products, profit can be generated out of price differences between them and other index products.
Disadvantages of ETFs
Now that I have talked about the advantages, let us discuss the disadvantages when it comes to ETF.
1.Though there are chances of arbitrage in case of ETFs, institutional and big investors pounce into it to plug any price difference;
2. ETFs are gaining exposure in India at a good pace. However, if you compare the liquidity of ETFs vis-à-vis mutual funds, you will see that the liquidity of mutual funds is quite high;
Also, unlike a regular mutual fund, AMCs do not deal directly with small investors. In case there is not much liquidity in a product that we want to buy or sell, we can ask the AMC to provide us details of the ‘authorized participant who buys or sells quotes related to ETFs.
In this situation, these authorized participants come to the rescue;
3.Also, SIP are not a convenient option in case of ETFs as is the case with mutual funds as active fund management takes place in case of mutual funds. Though investors can opt for SIPs, the liquidity and management expertise is an issue;
4. The number of investment options is a lot in case of ETFs. Hence, deciding on a particular instrument can sometimes be very difficult for an investor.
While the number of ETFs for investment continues to expand, simple portfolios consisting of handful of stocks can also help you achieve your goal.
Tax Applicable in Case of ETFs
To understand the taxability of various types of ETFs, let us look at the chart below:
|Parameter||Gold ETF||Index ETF||International ETF||Sector specific ETF|
|Short term capital gains||As per the income tax slab||15%||As per income tax slab||15%|
|Long term capital gains||10% without indexation or 20% with indexation||Nil||10% without indexation or 20% with indexation||Nil|
|Securities Transaction Tax (STT)||Nil||0.125%||Nil||0.125%|
Note: In case of Gold ETF, the short term holding period is less than three years, whereas long term is more than three years. Whereas in case of other funds, the short term holding period is less than one year whereas long term is more than one year.
Most Actively Traded ETFs in India
Few of the top ETFs in terms of AUM (Assets under management) along with the returns generated have been shown below in the table:
|Scheme||Asset Size (In crores)||1-Year returns||2-Year returns||3-Year returns|
|SBI – ETF Nifty 50||10,000||16.0%||14.2%||16.3%|
|SBI – ETF Sensex||10,000||18.5%||16.1%||17.1%|
|UTI Nifty Exchange Traded Fund||10,000||15.9%||13.5%||15.9%|
|Kotak Banking ETF||6088.74||24.2%||18.2%||23.2%|
|Reliance ETF Bank BeES||4966.80||24.3%||18.2%||23.2%|
|UTI Sensex ETF||3738.23||18.6%||15.1%||16.5%|
While looking at the returns, we can say that both the Nifty and Sensex ETF have given handsome returns to investors at a very low cost.
At the same time, some banking sector ETFs have performed tremendously such as that of Reliance ETF Bank BeES and Kotak Banking ETF.
As we have reflected on almost all aspects of ETFs, it is now for you to decide whether or not you should include this product in our portfolio.
At the later stage wherein you look at the returns of various index ETFs and sector ETFs, you can make out that it can be one of the best-suited products for you in the long run, given the benefits it provides not just in terms of returns but also in the case of ease of use and lower expense ratio.
Though Indian ETFs are at an emerging stage as compared to the ETF market globally, sooner or later, given the benefits it will catch up to the global markets.
Also, actively managed funds will always be striving for greater alpha, but passively managed products such as ETFs will help investors in quick diversification across asset classes.
Therefore, we can seriously think of including this product to meet our long term needs. The table below highlights the type of investor and usefulness of ETFs:-
|Type of Investor||Investment Horizon||Usefulness|
|Retail or Wholesale Investor||Long term||Diversification of portfolio|
|FIIs / Institutions and Mutual Funds||Long term / Short term based on various parameters||Asset allocation, hedging, equitizing cash at a low cost|
|Arbitrageurs||Short term||Low impact cost to carry arbitrage opportunities|
|Short term retail investor||Short term||Access to liquidity|
Disclaimer: The views expressed in this post are that of the author and not those of Groww