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Let's Talk About ETFs: What is it? Why is it Important?

What is an ETF?

Exchange traded fund (ETF) are funds that track indexes such as Nifty 50 or BSE Sensex.

ETFs unlike regular mutual funds, trades like a common stock on a stock exchange. You can buy shares/units of an ETF, on the stock exchanges. The units of an ETF are traded via brokers registered with the stock exchanges.

ETF units are listed on stock exchanges and the net asset value (NAV) varies as per market movements.

Since units of an ETF are listed in the stock exchange only, they are not bought and sold like any normal open-ended equity fund. An investor can buy as many units as he/she wishes without any restriction through the exchange.

How do Exchange Traded Funds (ETFs) Work?

ETFs are listed on all major stock exchanges and can be bought and sold as per requirement during the equity trading time.

Changes in the share price of an ETF depends on the cost of the underlying assets present in the pool of resources. If the price of one or more asset rises, the share price of the ETF rises proportionately, and vice-versa.

The value of the dividend received by the shareholders of ETFs depends upon the performance and asset management of the concerned ETF company.

They can be actively or passively managed, as per company norms.

Actively managed ETFs are operated by a portfolio manager, after carefully assessing the stock market conditions and undertaking a calculated risk by investing in the companies with high potential.

Passively managed ETFs, on the other hand, follow the trends of specific market indices, only investing in those companies listed on the rising charts.

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How are ETFs different from stocks?

Stocks represent shares within individual companies, whereas ETFs offer shares of multiple companies in a packaged bundle.

ETFs aren't bound to a single company, so they can contain stocks in a particular sector or contain stocks that approximate a particular index, like the Nifty 50, which contains stocks in multiple sectors.

The number of shares per stock tends to be stable, although this is not always the case.

Stock buybacks, splits, and secondary offerings may change the number of shares per stock, but these don't happen with the same regularity as they do with an ETF.

The number of shares per ETF change so that the share price matches the NAV as closely as possible.

The NAV measures the aggregate value of stocks and shares within an ETF, compared to the index that the ETF is intended to approximate.

Different types of ETFs

Index ETFs

Most ETFs are index funds that attempt to replicate the performance of a specific index.

Indexes may be based on the values of stocks, bonds, commodities, or currencies.

An index fund seeks to track the performance of an index by holding in its portfolio either the contents of the index or a representative sample of the securities in the index.

ETFs replicate indexes and such indexes have varying investment criteria, such as minimum or maximum market capitalisation of each holding.

Gold ETFs

This is a commodity ETF primarily involving physical gold assets.

Purchasing shares of this company allows you to become the owner of gold on paper, without the burden of asset protection.

To know more about the latest stock price details of India's top gold ETF stocks, you can check out the page on our website.

Currency ETFs

Currency ETFs are pooled investment vehicles that track the performance of currency pairs, consisting of domestic and foreign currencies.

Currency ETFs serve multiple purposes.

They can be used to speculate on the prices of currencies based on political and economic developments for a country.

They are also used to diversify a portfolio or as a hedge against volatility in forex markets by importers and exporters.

Some of them are also used to hedge against the threat of inflation.

Debt ETFs

Debt ETFs are simple investment products that allow the investors to take an exposure to the fixed income securities.

These debt ETFs combine the benefits of debt investments with the flexibility of stock investment and the simplicity of mutual funds.

These debt ETFs trade on the cash market of the NSE, like any other company stock, and can be bought and sold continuously at live market prices.

Debt ETFs are passive investment instruments that are based on indices and invest in securities in same proportion as the underlying index.

Because of its index mirroring property, there is a complete transparency on the holdings of an ETF.

Further due to its unique structure and creation mechanism, all the types of ETFs have much lower expense ratios compared to mutual funds or physical gold investments.

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Benefits of investing in ETFs

Low cost

The biggest advantage of investing in ETFs is cost efficiency.

The expense ratio of an ETF is usually less than 0.5% compared to 2-2.5% for actively managed equity funds.

A lower fund management fee generates incremental savings which can result in increased payouts in the long-run.

Liquid

Since ETFs are marketable securities, they can be traded on registered bourses. Since an ETF can be bought and sold at any time in the day (during trading hours) it is more liquid compared to other investment products such as mutual funds or Public Provident Fund (PPF).

One reason is that the price or NAV of an ETF can fluctuate throughout the day.

On the other hand, a mutual fund is usually bought or sold directly with the fund house at the declared NAV of the day.

Transparent

As ETFs track an underlying index, you know beforehand which stocks it will hold and in what proportion.

For example, the Nifty 50 is composed of the 50 largest listed companies in India by market capitalisation. An ETF tracking the Nifty 50 will hold these exact companies and in the same weights as the Nifty.

It will also rebalance its holdings when the index composition changes.

Diverse products

ETFs in India track diverse products like the Nifty, gold, Nifty Next 50, Nifty Low Vol 20 index, and several others. You may not find active mutual funds tracking all these products.

No fund manager error problem

Since an ETF tracks an index, it does not rely on active investment calls provided by a fund manager. Hence it is not affected by the errors that a fund manager might make.

It can sometimes have an error in tracking the index (called tracking error), but this is usually small in magnitude and therefore, can be ignored.

Efficient market hypothesis

According to the efficient market hypothesis, no fund manager can outperform the market forever and outperforming strategies are quickly imitated and arbitraged away.

Hence in the long run, simply investing in the whole market passively tends to outperform active stock picking.

If you believe in this financial theory, ETFs are a better product than actively manages funds.

Limitations of ETFs

Need demat and trading account

Since ETFs require demat and trading accounts, investing in them is not practical for investors who do not have such accounts.

Many mutual fund investors do not have such accounts since they are not required for investing in ordinary mutual funds.

Brokerage fees

One can either opt for a fund manager to handle their funds or manage the funds by the themselves by opening a demat account.

If a fund manager is appointed then the investor may incur some commission fee costs.

Market volatility

ETFs heavily depend on the market trends. Hence, in good times the investor may earn handsome profits while in bad market conditions the investor may also incur heavy loses.

Giving up alpha

An ETF investor is giving up the potential to outperform (called alpha) since he/she is only passively tracking the index.

An actively managed fund can not only give you the index return but also beat it especially in emerging markets such as India.

Limited growth upside

Usually, only mature companies make it to indices like the Nifty or Sensex. Such indices only include the largest companies by size and many of these companies have put their best years of growth behind them.

So ETF investments cannot tap the opportunities to earn higher returns in high growth potential companies in small and mid-cap space.

Best performing ETFs in India

Here's the list of top ETFs and their performance for the last two years.

Data Source: Company's website

Should you invest in ETFs?

A few years back, the legendary investor, Warren Buffett advised his own family to put his wealth in index funds after he is gone - such is his conviction that index funds will beat actively managed funds in the long term.

His belief is not without basis - more than 90% of large cap companies in the US failed to beat the S&P 500 index over long investment tenor.

If you look at the last 1 year in the Indian share markets as well, ETF funds have beaten most equity mutual fund categories.

This may simply be due to market conditions which favoured large cap, but the interesting point here is that ETFs were able to beat large cap equity mutual funds.

While awareness about ETFs is quite low in India, these funds are gaining traction among investors over the last few years.

In the last 5 years, the mutual fund industry assets under management (AUM) in ETFs have grown at a compound annual growth rate (CAGR) of more than 100%.

In the developed markets, ETFs and index funds are hugely popular with investors.

To conclude, ETFs are excellent investment options for passive investors, who want to beat inflation and get returns over a long investment horizon.

Actively managed funds will continue to form the major part of investment portfolios, but ETFs and index funds will gain an increasing share of wallet over time.

Investors should educate themselves about ETFs and index funds, so that they can take informed investment decisions.

Here are links to some insightful Equitymaster articles and videos on ETF

Happy Investing!

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