What is an Exchange Traded Fund?
Meaning of Exchange Traded Fund (ETF): – Exchange Traded Fund (ETF) is a collection or basket of securities which tracks the performance of its benchmark index. This benchmark index can be BSE Sensex, Nifty 50, S&P BSE Banks etc. When you buy shares or units of an ETF, you are buying shares or units of a portfolio that tracks the yield and return of its native index. The unique selling point (USP) of ETFs is the fact that it can be traded on stock exchanges on real-time basis like equity shares. An exchange traded fund (ETF) is a basket of securities that trade on an exchange just like a stock does.
Its aim is to give investors a cost-effective and convenient method to invest in all the nifty 50 stocks collectively. Exchange traded funds (ETFs) are a type of investment fund that offer the best features of two popular assets: – They have the diversification benefits of a mutual fund, while being easily traded in stocks.
Exchange Traded Fund (ETF)
An exchange-traded fund, or ETF, is a fund that can be traded on an exchange like a stock, which means it can be bought and sold throughout the day. The price of an exchange traded funds (ETFs) shares will change throughout the trading day as the shares are bought and sold on the market. This is unlike mutual funds, which are not traded on an exchange, and trade only once per day after the markets close. Exchange traded fund or ETFs often have lower fees than other types of funds. Depending on the type, ETFs carry different levels of risk.
But like any financial product, Exchange traded fund are not a one-size-fits-all solution. Evaluate them on their own merits, including management costs and commission fees (if any), how easily you can buy or sell them, and their investment quality.
Exchange traded funds (ETFs) can trade like stocks, but under the hood they resemble mutual funds and index funds, which can differ greatly in terms of their underlying assets and investment goals. These exchange traded funds are not classified by management type (passive or active), but by the types of investments held within the exchange traded fund.
Types of Exchange Traded Funds (ETFs)
Exchange traded fund is not just a collection of stocks. It can be based on any underlying asset. There are various types of ETFs available to investors that can be used for income generation, speculation, price increases, and to hedge or partly offset risk in an investor’s portfolio.
Here is a list of some of the Exchange Traded Funds (ETFs) available in the market: –
- Stock Exchange Traded Funds (ETFs): – Stock Exchange Traded Funds (ETFs) is a collection of equity stocks to track a single industry or sector. For example, a stock ETF might track automotive or foreign stocks. The aim is to provide diversified exposure to a single industry, one that includes high performers and new entrants with potential for growth. Unlike stock mutual funds, stock ETFs have lower fees and do not involve actual ownership of securities. These include stocks and are usually meant for long-term growth. While generally less risky than individual stocks, they carry a bit more risk than some of the others listed here, such as bond ETFs.
- Commodity Exchange Traded Funds (ETFs): – Commodity Exchange Traded Funds (ETFs) invest in commodities, including crude oil or gold. Commodity ETFs provide several benefits. First, they diversify a portfolio, making it easier to hedge downturns. For example, commodity ETFs can provide a cushion during a slump in the stock market. Second, holding shares in a commodity ETF is cheaper than physical possession of the commodity. This is because the former does not involve insurance and storage costs. Commodities are raw materials that can be bought or sold, such as gold, coffee and crude oil. Commodity ETFs let you bundle these securities into one investment.
- Bond Exchange Traded Funds (ETFs): – Bond Exchange Traded Funds (ETFs) are used to provide regular income to investors. Their income distribution depends on the performance of underlying bonds. They might include government bonds, corporate bonds, and state and local bonds called municipal bonds. Unlike individual bonds, bond Exchange Traded Funds (ETFs) do not have a maturity date, so the most common use for them is to generate regular cash payments to the investor. They generally trade at a premium or discount from the actual bond price. These payments come from the interest generated by the individual bonds within the fund. Bond ETFs can be an excellent, low-risk complement to stock ETFs.
- Currency Exchange Traded Funds (ETFs): – Currency Exchange Traded Funds (ETFs) allow an investor to participate in currency market transactions without purchasing a specific currency. The motive of such investments is to track and benefit from the price fluctuations of a particular currency or a basket of 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. There’s even an ETF option for Bitcoin.
- International Exchange Traded Funds (ETFs): – Foreign stocks are widely recommended for building a diversified portfolio along with U.S. stocks and bonds. International Exchange Traded Funds (ETFs) are an easier and usually less risky way to find these foreign investments. These ETFs can include investments in individual countries or specific country blocks.
- Sector Exchange Traded Funds (ETFs): – Sector Exchange Traded Funds (ETFs) provide a way to invest in specific companies in those sectors, such as the health care, financial or industrial sectors. These can be especially useful for investors tracking business cycles, as some sectors outperform during expansion periods, others outperform during contraction periods. The idea behind Sector ETFs is to gain exposure to the upside of that industry by tracking the performance of companies operating in that sector. One example is the technology sector, which has witnessed an influx of funds in recent years. At the same time, the downside of volatile stock performance is also curtailed in an ETF because they do not involve direct ownership of securities. Industry ETFs are also used to rotate in and out of sectors during economic cycles.
- Inverse Exchange Traded Funds (ETFs): – Inverse Exchange Traded Funds (ETFs) attempt to earn gains from stock declines by shorting stocks. Shorting is selling a stock, expecting a decline in value, and repurchasing it at a lower price. An inverse ETF uses derivatives to short a stock. Essentially, they are bets that the market will decline. When the market declines, an inverse ETF increases by a proportionate amount. Inverse Exchange Traded Funds (ETFs) are designed to return the opposite of what is offered by the underlying market index. With these funds, share prices move in the opposite direction of the inverse ETFs’ share. Investors should be aware that many inverse ETFs are exchange traded notes (ETNs) and not true ETFs. An ETN is a bond but trades like a stock and is backed by an issuer like a bank. Be sure to check with your broker to determine if an ETN is a good fit for your portfolio.
How do Exchange-Traded Funds work?
An exchange traded fund works like this: – The fund provider owns the underlying assets, designs a fund to track their performance, and then sells shares in that fund to investors. Shareholders own a portion of the exchange traded fund, but they do not own the underlying assets in the fund. Nevertheless, investors in exchange traded fund that track a stock index may receive a lump-sum dividend payment or reinvestment for the stocks that make up the index.
Changes in the share price of an ETF depend on the costs 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 share-holders 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.
While exchange traded fund are designed to track the value of an underlying asset or index whether it’s a commodity like gold or a basket of stocks like the S&P 500 — they trade at market-determined prices that typically differ from that property. What’s more, due to things like expenses, the long-term returns for an ETF will differ from those of its underlying assets.
Here’s an abridged version of how Exchange traded funds work: –
- An ETF provider considers a universe of assets, including stocks, bonds, commodities or currencies, and creates a basket of them with a unique ticker.
- Investors can buy a part of that basket, just like buying shares of a company.
- Buyers and sellers trade exchange traded funds on the exchange throughout the day, just like stocks.
Advantages and Disadvantages of Exchange Traded Fund
Exchange traded fund offer lower average costs because it would be expensive for an investor to purchase all the stocks held in an exchange traded fund portfolio individually. Investors only need to execute one transaction to buy and one transaction to sell, leading to lower broker commissions as only a small number of trades are being made by investors. Brokers usually charge a commission for each trade. Brokers usually charge a commission for each trade. Some brokers also offer no-commission trading on some low-cost exchange traded funds, further reducing the cost to investors.
The expense ratio of an exchange traded fund is the cost of operating and managing the fund. Exchange traded funds typically cost less because they track an index. For example, if an exchange traded fund tracks the S&P 500 index, it may contain all 500 of the S&P stocks, making it a passively managed fund that is less time-intensive. However, not all exchange traded funds passively track indexes.
What are the advantages of Exchange Traded Funds?
The advantages of Exchange Traded Funds are as follows: –
- Diversification: – An exchange traded fund can provide exposure to a group of equities, market segments or styles. An ETF may track a wide range of stocks, or may even attempt to mimic the returns of a country or group of countries. Investing in exchange traded funds allow you to keep your finances spread over equities of different companies diluting your risk significantly. Even if one asset underperforms in the pool of resources in an ETF, it can be compensated by the exceptional growth of other assets.
- Trade like a Stock: – Although exchange traded fund can give the holder the benefit of diversification, it has the trading liquidity of equities. Specially: –
- ETFs can be bought on margin and sold short.
- ETFs trade at a price that is updated throughout the day. On the other hand, an open-ended mutual fund is priced at the net asset value at the end of the day.
- ETFs allow you to manage risk by trading futures and options just like stocks.
- Lower Fees: – One of the significant benefits of investing in an ETF over mutual funds is the reduced expenses. There are various charges involved in mutual funds, such as entry and exit load, management fees, etc. This increases your total cost incurred, and thereby the total expense ratio of mutual funds. As ETFs are traded like shares in the stock market, its expense ratio is considerably lower. Exchange traded funds which are passively managed, have much lower expense ratios than actively managed funds, which are mutual funds. Costs such as management fees, shareholder accounting expenses at the fund level, service fees such as marketing, payments to the board of directors, and load charges for sales and distribution.
- Immediately Reinvested Dividends: – In open-ended exchange traded funds, companies’ dividends are reinvested immediately, while the exact timing for reinvestment can vary for index mutual funds. (One exception: Dividend ETFs are not automatically reinvested in unit investment trusts, thus creating a dividend drag.)
- Passively Managed: – Investing in ETFs is generally less risky than mutual funds as they are passively managed. They only invest in the best-performing companies listed in a particular stock exchange, while mutual funds thoroughly assess all the businesses with a potential for growth. This subjects mutual funds to a greater risk as newly formed small scale companies have higher chances of incurring a loss.
- Limited Capital Gains Tax: – ETF funds are more tax-friendly than mutual funds. Even though both are subjected to capital gains tax and dividend taxes, the relative amount of fee charged on ETFs is much lower than the one levied on mutual funds. Exchange traded funds can be more tax-efficient than mutual funds. As passively managed portfolios, ETFs (and index funds) yield lower capital gains than actively managed mutual funds.
- Mutual funds, on the other hand, are required to distribute capital gains to shareholders if the manager sells securities for a profit. This distribution amount is made in proportion to the investments of the holders and is taxable. If other mutual fund holders sell before the record date, the remaining holders split the capital gains and thus pay taxes, even if the value of the fund is reduced.
- Lower Discount or Premium in Price: – Exchange traded fund share prices are less likely to be higher or lower than their actual value. ETFs trade at a price close to the price of the underlying securities throughout the day, so if the price is significantly higher or lower than the net asset value, arbitrage will bring the price back in line. Unlike closed-end index funds, ETFs trade based on supply and demand, and market makers will capture price discrepancy gains.
- Tradable Security: – Any changes in the value of an ETF can be observed instantly and can be bought and sold throughout the business day. Thus, we can conclude that ETFs have much higher liquidity than mutual funds. This enables you to have flexibility in your choices of investing, allowing you to shift to another security with ease in case a particular asset is not generating adequate profits.
What are the disadvantages of Exchange Traded Funds?
The disadvantages of Exchange Traded Funds are as follows: –
- Less Diversification on Small Scale Companies: – For certain sectors or foreign stocks, a narrow group of equities in a market index may limit investors to large-cap stocks. Lack of exposure to mid- and small-cap companies can put potential growth opportunities out of reach for exchange traded funds investors. Exchange traded funds have moderate diversity. As most ETFs are passively managed, they generally invest in best-performing companies listed on a particular stock exchange. ETF organisations often overlook small scale companies with huge potential.
- Intraday Pricing may be Overkill: – Long-term investors may have a time horizon of 10 to 15 years, so they may not benefit from intraday pricing changes. These backward swings in hourly prices may cause some investors to overtrade. A swing high in a few hours can prompt a trade where pricing at the end of the day can keep irrational fears from distorting an investment objective. Since ETFs are traded like shares, there are several expenses that have to be incurred to purchase them. This is generally done by the fund managers, who charge a nominal commission fee for such transactions.
- Transaction Cost may be Higher: – Most people compare trading ETFs to trading other funds, but if you compare exchange traded funds to investing in a specific stock, the cost is higher. The actual commission paid to the broker may be the same, but there is no management fee for the stock. So, whenever you buy and sell ETFs you have to pay securities transaction tax (STT) and hefty brokerages. The more buying and selling you do, the more taxes and brokerages you pay. In addition, as more specialized exchange traded fund is created, they are more likely to follow a lower-volume index. This can result in a higher bid/ask spread. You may get a better price by investing in genuine stocks.
- Lower Dividend Yields: – There are dividend-paying exchange traded funds, but the return may not be as high as owning a high-yield stock or group of stocks. The risks associated with owning an exchange traded fund are generally low, but if an investor can afford the risk, the dividend yield of stocks can be very high. While you can choose the stocks with the highest dividend yields, exchange traded funds track a broader market, so the overall yield will be lower than average.
- The Volatility of the Stock Market: – Exchange Traded Funds companies listed on a stock exchange are subject to price fluctuations as per market trends. They are not stable like government bonds. Earning a profit or incurring a loss depends heavily on the stock market conditions.
How to identify a good exchange traded fund for investment purposes?
When buying shares, investors study the fundamentals of the company. They might conduct top-down or bottom-up investment approach to selecting stocks. Whereas in mutual funds, investors pass this responsibility to the fund managers.
Like mutual funds, investors have no control on the underlying portfolio of an exchange traded fund. But still, there are certain things that investors must consider while selecting best ETFs.
- Liquidity & Average Daily Volume: – Liquidity is an important parameter when selecting best ETFs for investment. Liquidity decides the ease with which you can enter and exit an exchange traded fund. Even the size of your investment is dependent on liquidity. Best ETFs are those that have high trading volumes and low bid-ask spreads. It is recommended that investors must check the average daily trading volume of ETFs before investing.
- Tracking Error: – This is the difference between the returns generated by the exchange traded fund and its benchmark. Best ETFs are ones which have very low tracking error. Remember, the lower the tracking error, the better is the ETF’s performance. If there is a significant deviation in the performance of the exchange traded fund and the benchmark, then it’s better to avoid that exchange traded fund.
- Expense Ratio: – The expense ratio of a fund covers the cost of running the fund. This includes paying the fund manager’s salary, operational and legal costs etc. All this comes out of the investors pocket as it is deducted from the fund’s NAV. Since equity mutual funds are actively managed, their expense ratios are high. But being passively managed, ETFs have very low expense ratios. This directly increases an investor’s portfolio returns.
- Impact Cost: – When investing in ETFs, you need to worry about the total cost of ownership. This includes the TER, brokerage and bid-ask spread. Higher the bid-ask spread; the higher will be the impact on the investor. A wide bid-ask spread could be due to low liquidity. Best ETFs are the ones which have very low impact cost.
Top 10 Exchange Traded Funds in 2021
|S.No.||Top Performing ETFs||NAV||Assets (Rs. cr.)||1-year Return||2-year Return||3-year Return|
|1.||Nippon India ETF PSU Bank BeES||26.9||278.74||93.44||3.55||-3.27|
|2.||Kotak PSU Bank ETF||243||137.38||93.02||3.31||-3.47|
|3.||CPSE Exchange Traded Fund||30.52||9,854.40||85.52||13.1||4.66|
|4.||Motilal Most Oswal Midcap 100 ETF||31.99||58.92||79.59||38.06||21.57|
|5.||Edelweiss ETF – Nifty Bank||4,000.10||1.1||75.01||13.06||14.11|
|6.||SBI – ETF Nifty Bank||371.76||4,257.91||74.79||12.65||13.79|
|7.||Nippon India ETF Bank BeES||374.81||8,257.10||74.72||12.6||13.75|
|8.||Kotak Bank ETF||376.34||7,281.20||74.58||12.49||13.69|
|9.||Kotak NV 20 ETF||98.06||23.22||66.5||31.29||20.96|
|10.||ICICI Prudential NV20 ETF||96.41||16.88||66.46||31.38||21.02|
Exchange Traded Funds vs. Mutual Funds
|S.No.||Key Pointers||Exchange Traded Funds||Mutual Funds|
|1.||Definition||Exchange Traded Fund is a basket of stocks which are traded on the stock exchange.||Mutual fund is an investment vehicle which pools funds from various investors and invests in stocks as per the fund’s investment objective.|
|2.||Pricing||ETFs are traded at market price.||Mutual Funds are traded at closing NAV for a particular day.|
|3.||Expenses||ETFs have low operating expenses as they are passively managed.||Mutual Funds have higher operating expenses as fund management fees have to be paid.|
|4.||Minimum Investment||There is no minimum value specified for ETFs. But investors need to buy at least 1 unit of any ETF.||The minimum investment amount in mutual fund varies from Rs 100 to Rs 500.|
|5.||Trading Timings||ETFs can be purchased at any time during market hours.||There are predefined timings before which an investor needs to place an order to get the same day’s NAV.|
|6.||Transaction Cost||There is an additional impact cost, which may come in the form of high bid-ask spread.||There is no transaction cost compared to ETFs.|
|7.||Loads||There is no entry or exit loads for ETFs. This makes it easy for investors to buy or sell the investments quickly.||Entry load in mutual funds has been banned by SEBI. But mutual funds do charge exit load on premature withdrawals.|