A Comprehensive Guide to Exchange-Traded Funds
Exchange-traded funds or ETFs were launched in India towards the end of 2001 and remained rather nonexistent for over a decade. It was, in fact, the government’s efforts that gave ETFs a fresh lease of life. Firstly, with its recognition as an asset class in 2013, then the government’s disinvestment initiative in 2014 through ETFs, and most importantly, the Employee Provident Fund Organization’s decision to invest five percent of the incremental monthly inflows into ETFs. This gave a big boost to the structure and from an insignificant 12,000 crores in FY 2015, this instrument now has an AUM of over 4 lakh rupees. So in this article, we shall examine ETFs in greater detail: What is an ETF? How does it work? How does it compare with index funds and stocks? Its benefits and drawbacks? Let’s begin.
What is an ETF? How does it work?
An ETF is a tradable security that tracks either an index, a commodity, bonds, or any basket of assets. There are two important phrases to focus on here. The word “tradable” means an ETF works a lot like a stock, which means it can be bought and sold on a stock exchange during trading hours. Consequently, the ETF’s trading value depends on the NAV of the underlying asset that it represents. And speaking of assets, this brings us to the second phase of our definition, which says that an ETF tracks either an index, a commodity, bonds, or any basket of securities. In that context, a good representative sample of an index will be the Nifty 50 index, whose value is what a Nifty 50 ETF would track and replicate. Likewise, the ever-popular Gold ETF would be a worthy example of an ETF that tracks the commodity, whose trading value is tightly aligned to the domestic price of gold. This authorized participant then buys the underlying securities and delivers them to the ETF issuer, who, in return, gives the authorized participant a block of ETF shares that can then be sold in the open market. This in-kind transaction in ETF balance is called creation. Now, as you might have guessed, the same process works in reverse at the time of redemption, with the authorized participant now buying ETF shares to be returned to the issuer.
How does it compare with index funds and stocks?
ETFs, index mutual funds, and stocks represent three different asset classes. For all practical purposes, now the most visible confusion here is between an ETF and an index fund, and one can understand why. After all, both constitute a portfolio of assets, they both track the index, and both of them are generally passive in their management. But there are differences. For instance, ETFs are listed on the stock exchange, which makes them tradable during market hours. The ETF prices fluctuate throughout the day, and one needs to have a DMAT account to trade in ETFs, which is not required for index funds. When we add stocks to this comparison, then this contrast becomes even more apparent. For instance, stocks are actively managed, while ETFs are generally passive. Stocks don’t have a tracking error or an expense ratio, while ETFs have that. Stocks are concentrated bets, while ETFs are a lot more diversified.
The different types of ETFs, Expenses and Taxation
ETFs have low turnover, which keeps their expense structure extremely low. The minimum investment is generally one unit, and ETFs are a very handy instrument for diversification and risk management. Now, on the flip side, exchange-traded funds also come with some disadvantages. Firstly, and this is super obvious, ETFs are passive instruments, which means they are not built to outperform the index that they are tracking. So if the Nifty 50 were to grow by 12% over a year, we can expect the Nifty 50 ETF to have delivered 12% or less during the same time. Now, this is generally not a problem for broad-based ETFs like the Nifty 50 or government securities or gold ETFs, but this might be a problem for the more thinly traded ones. A third concern with ETFs is the tracking error, which measures the difference in the ETF’s performance with the index that it tracks. Now, a tracking error is a function of multiple things: delays in the purchase and sale of securities, expenses of the scheme, the ETF’s cash holdings, delays in the deployment of dividends, etc.
While the expense ratio of an ETF is generally low, certain other costs are unique to it. For example, since ETFs are traded through a broker, a brokerage or commission might be applicable on a buy or sell transaction. In addition to brokerage, there are other costs like exchange transaction charges, securities transaction tax, stamp duty, and of course, the GST that the investor has to incur in the course of these transactions. Then there is the expense ratio, which the ETF issuer charges to cover the administrative costs of providing the investment instrument.
