Exchange Traded Funds (ETFs) are becoming very popular with each passing day. The first ETF in India was launched in 2001 and presently there are more than 100 ETFs listed on the exchanges. Warren Buffet reportedly wants his trust (after his passing away) to invest 90% in ETFs linked to the S&P 500 and only 10% in cash. There would certainly be some good reasons why one of the greatest investors of all times recommends Exchange Traded Funds (ETFs).
What is an Exchange Traded Fund (ETF)
An ETF is basically a Mutual Fund akin to an Index Fund or Commodity based Fund. It invests in securities which could either be based on a particular index, in assets like Gold. ETFs are listed on the stock exchanges where we can buy their units just like other stocks. If it is an Index based ETF, then the basket will have stocks in the same proportion as the benchmark Index. In case of Gold based ETFs, the underlying is Gold of 0.995 purity. In simple terms it is a Mutual Fund Unit which can be bought/sold on the exchange during trading hours just like any other share.
The Mutual Fund Schemes define the price of a Mutual Fund unit in terms of NAV on a daily basis. However, the price of an ETF is dynamic and keeps changing during trading hours reflecting changes in the value of the underlying securities/assets. So, in the case of a Mutual Fund the investor can at best decide the day of purchase and accept that day’s NAV. While in the case of ETF we can exploit the intraday volatility and choose the price also.
Advantages of Exchange Traded Funds (ETFs)
The ETFs have significant advantages over passive Mutual Funds.
Low Cost
The foremost benefit of ETFs is there very low cost. As there is no active decision making involved, there are negligible fund manager expenses. Further there is almost no churning of portfolio other than to reflect changes in the underlying index. This reduces the transaction costs significantly. Many of the good performing Nifty 50 ETFs have expense ratios as low as 0.05%.
Diversification
An ETF gives diversification at very low cost. One unit of Nifty 50 ETF gives exposure to 50 different blue chip stocks and helps spread risk with one decision.
Live Price
Unlike a Mutual Fund, investors can see the changing price on screen and place buy/sell orders just like any other stock. This is a significant advantage over other Mutual Funds where the day’s NAV for all investments/redemptions on any given day are same for everyone. In the case of ETFs the you can factor the day time volatility while making buy/sell decisions.
No Time lag in Investment and Redemption
In the case of Mutual Funds there is a time lag between receipt of funds by the scheme and purchase of securities. The markets in the intervening period might move upwards making the purchase costly for the investor. In the case of ETFs, the price is always current.
Complete Investment in the Intended Asset Class.
The open-ended Mutual Funds must retain some cash to cater for redemptions. These liquid assets may not be the intended asset class of the investor. In the case of ETFs, this requirement is absent. The complete investment remains deployed in the basket of securities/asset which the investor desires.
How to invest in ETFs
In the case of Mutual Funds, the requirement of a Demat and Trading Account is not necessary. However, to purchase ETFs the investor should have a Demat and trading account. Investing in ETFs is similar to buying any other stock through the exchange. Those who have a trading account can invest in ETFs through their trading account or through their brokers.
How to Choose an ETF
There are different fund houses offering a variety of ETFs. The key choice is the underlying index or the asset that one wants to invest in. After identifying the category, one can compare the options for following factors.
Liquidity
It is very important to have liquidity so that one can exit when desired. Not all ETFs have high liquidity. One can check from the NSE Site (Market Watch-Exchange Traded Funds) and opt for an ETF which has more volume of trades every day.
Tracking Error
All ETFs will have a benchmark index. For example, Nippon Bees ETF reflects S&P CNX Nifty. The difference in movement of the fund as compared to that of the benchmark is the tracking error. You should prefer an ETF with lower tracking error.
Expense Ratio.
The overall expense ratio of ETFs is low as compared to corresponding Index/commodity mutual funds. The expense ratio of different ETFs with same benchmark index might be different. You may prefer one with lower expense ratio.
Asset Under Management (AUM) and Past Performance
While AUM may not directly affect the performance of the index, it indicates the preference of investors at large. Also with large AUM, the scheme can cut down costs and pass on the benefits to their investors. Just like other Mutual Funds, investor must measure the past performance of at least three years. New offers do not have any track record of past performance. I therefore do not recommend them unless the NFO is offering some hitherto non-existent theme.
Recommendations
- Open a Demat and Trading Account if you do not have it already.
- Keep a healthy proportion of investments in ETFs.
- ETF should be preferred over a Mutual Fund for a given theme/asset.
- Evaluate ETFs for tracking error, expense ratio, AUM and past performance.
3 replies on “Exchange Traded Funds (ETFs)”
Very informative article. ETFs can be a path for investment and their performance will be almost like the spectrum of underlying. With the potential of Indian market, ETFs can provide excellent returns for investment.
As always very lucidly explained. Thanks Rajesh for making us wiser on issues of personal finance
Simplistic narrative on a rather intricate subject wherein author has very aptly presented not so familiar saving instrument i.e ETFs and benefits thereof over the otherwise preferred Mutual Funds.