An exchange traded fund (ETF) is essentially an index fund that trades like a stock and is listed on the exchange. Although popular abroad, it is still a new concept in India. Currently, India has 16 ETFs, with total assets under management of Rs4,182crore in September 2008. In the US, by contrast, there are 707 ETFs, with combined assets of $585.9 billion or Rs27.5lakhcrore.
An ETF is a single security representing a basket of stocks that corresponds to a particular index, say, the S&P CNX Nifty or Sensex. The ETFs trading value is based on the net asset value of the underlying stocks that it represents. Much like an index fund, an ETF offers built-in diversification. But because ETFs can be bought or sold within the trading day, they offer the flexibility of a stock. Like individual equity securities, ETFs are traded on a stock exchange and can be bought and sold throughout the day through a broker-dealer, just like Infosys or Reliance Industries shares.
The popularity of exchange traded funds is growing: they combine diversification, cost efficiency and flexibility in a single investment. Firstly, with an ETF, you trade a basket of stocks for a single brokerage, saving money on trades. Secondly there are no short-term redemption loads. Thirdly, ETFs allow you to take advantage of intraday changes in the market, as they trade throughout the day, like stocks. Lastly, they let you benefit from sophisticated trading strategies such as hedging, diversification, and arbitraging between futures and cash market. And you can choose from a range of ETFs, including funds that modify standard indices and sector-specific funds.
ETFs can be broadly classified into index, commodity, and bond funds. Most ETFs are index funds that hold securities and attempt to replicate the performance of a stock market index. An index fund seeks track the index’s performance by holding either the contents of the index, or a representative sample of securities in the index.
Commodity ETFs invest in commodities such as precious metals and futures. In India, we only have gold ETFs. As for bond ETFs, there is currently only one available in India, namely Liquid BeES. There are other types of ETFs, such as currency ETFs and actively managed ETFs but they are not yet available in India.
ETFs trade like stocks, and like them, ETF units can be bought or sold through an equity broker of the exchange on which the fund is listed.
ETFs and index mutual funds both seek to match the return of a market index. Both suit investors looking for diversification. However, there are important differences.
The first is the minimum investment. For investors with limited funds (say less than Rs1000) who want to get started in the stock market, ETFs offer a cheap entry option, you can buy even one lone share, if you so choose. Index mutual funds require a minimum investment of Rs5,000.
Another difference is ease of use. ETFs can be bought or sold anytime the market is open, via your brokerage account. There are no hassles of filling up application or redemption forms, since you hold ETF units in your demat account. Index funds, on the other hand, can only be redeemed at the closing price of each day.
A third difference is in tracking error, which determines how closely an ETF mirrors the return of the underlying index. Generally, the tracking error of an ETF is lower than that of an index fund, indicating better replication of the underlying asset.
Fourthly, the expense ratio is generally lower for ETFs. And lastly, index futures give you tax benefits on only short-term capital gains, while ETFs give you long-term capital gains benefits, too.
Here are some guidelines to help you know when to consider an ETF and when not. If you are trying to get market returns, or believe the index will yield good long-term returns, ETFs may be a good choice because of their low cost and diversification. But ETFs make little sense if you are trying to beat the market, since they only track market indices.
When you are looking for wide diversification but have only a small sum to invest, an ETF may make sense. When you are unsure what to buy, but want to invest in equity, an ETF lets you invest in the stock market without betting on a particular company.