Exchange Traded Funds(ETFs)

ETFs are a fairly recent addition to the investor’s array of assets available to invest in. Exchange-traded funds are similar to mutual funds in the sense that like a mutual fund, an ETF also holds a basket of individual stocks, indices, bonds, or other asset classes like gold, crude oil, platinum etc. The focus of ETFs is on the word, “exchange-traded” because investors can buy or sell them on a stock exchange during trading hours, just like shares of a publicly traded company. Like the shares of any listed companies, these ETF trades can be executed through your trading account and can be held assets in your demat account

ETF prices fluctuate on a real-time basis based on how the underlying asset moves. To that extent, the ETF is a derivative product as its value is determined by the value of the underlying. This underlying could be an index, a set of stocks, gold, oil or even bond indices. Normally, an ETF unit is defined as a unit of the whole. For example, the normal unit for gold ETF is 1 gram of gold and if the gold spot price is Rs32,000 then the ETF unit will quote at around Rs3200. Even Nifty ETFs are quoted in such proportionate units. Investors can trade ETFs as frequently as they like. Globally, ETFs are heavily in demand by institutions and hedge funds, although in India it is more of a retail product.

ETFs may appear to be similar to mutual fund units but there is a small difference. Mutual funds are not geared for trading. In India, mutual fund units are available at their net asset value calculated and reported at the end of each trading day. When you trade ETFs, you don’t have exit loads or entry loads. You only have the commission to be paid. The costs in a typical ETF are lower than in the case of mutual funds and that makes it a better choice for individual investors.

It is interesting to understand how ETF units are created. In a mutual fund, it is the AMC that holds the portfolio of stocks and the mutual fund NAV is based on the value of the holdings adjusted for any liabilities and costs. However, in ETF, what is underlying and is it safe? For that, we need to understand how ETF units are actually created. Here are 4 steps.

• An ETF, like any mutual fund, is actually a "basket" of numerous stocks and other investment assets combined into a single investment product. An index ETF will also be backed by stocks underlying the index and a gold ETF will be backed by equivalent gold placed with a gold custodian bank. Normally, large institutions and HNIs participate in the creation of units. It is only possible with institutions and HNIs who have the capacity to put such an ETF size together.
• With the backers for an ETF identified, the AMC plans the ETF and decides what assets will be included and details such as fees and the number of shares that will be created. ETF being an exchange-traded product is subject to SEBI approval. Normally, it is after the approval that the authorized participants (large institutions and HNIs) will start buying shares of the ETF. Normally, ETFs don't sell their shares individually but sell huge chunks of shares and such chunks are referred to as creation units. Such creation units are normally too large for retail investors to participate in.
• Once the Creation units are ready, they are traded for equivalent amounts of the assets that the shares represent. These shares are placed with a custodial bank so that the ETF units that are issued to the retail investors are fully backed. This applies to index ETFs and also to gold ETFs. These ETFs are then managed by a fund manager whose primary role is to ensure that the portfolio reflects the underlying asset class and also to reduce the tracking error to the bare minimum.
• Authorized participants holding shares of the ETF can then trade those shares on the open stock market. Normally, authorized participants are also allowed to cash out by selling equivalent units to the ETF, which will then find another participant. This normally has a lock in. ETF units are then listed on a recognized stock exchange.

How can an investor put money in ETFs? These are ETFs are exchange trade products and hence can be purchased and sold in the stock markets. Here are the steps that an investor needs to go through while trading in ETFs.

• The investor needs to first have a trading account and a demat account with a recognized SEBI authorized broker. That is because, like shares, these ETF units are bought and sold through your trading account. When the delivery of these ETFs is done, then it gets directly credited to the demat account.
• The process flow is the same as in the case of buying and selling equities. You first have to fund your trading account to the extent of 100% of the investment. Then you can place the buy order based on the liquidity available. ETFs can only be purchased in the market if there is liquidity available. Once the order is placed and executed the trade is done. You will get the ETF contract note on the same day evening and the transaction entails payment of brokerage and other statutory charges like STT, GST, stamp duty, SEBI turnover tax, exchange charges etc.
• Like in the case of shares, the ETFs will also be credited to the specific demat account on T+2 day. Once you get the credit, you are free to sell these shares whenever you get a good exit opportunity.
• ETFs can be sold like any share in the stock market. You execute the trade in the stock market via your trading account subject to adequate liquidity. Once the trade is done, you get the contract note on the same day with all details. On T+2 by end of the day you get the money credit into your linked bank account. In case of global ETFs that are benchmarked to global indices, the payment cycle can take up to 6 days.

ETFs are simple products and can be purchased and sold like any stock in the market. It is also much simpler as the ETF can be held in custody in your demat account. Here are some really compelling reasons for you to invest in ETFs.

• ETFs are extremely simple to understand and easy to execute. They operate like any other equity asset and you can buy and sell like any stock. Unlike mutual funds that have to worry about redemptions, ETFs are not really worried about redemptions as market trading only leads to transfer of units and does not shift the AUM. Hence in case of index ETFs, the tracking error can be much lower than in the case of index funds.
• You can participate in asset classes that include indices, bonds, commodities, global asset classes. If you don’t want to go through the hassle of buying and selling physical gold, you can actually hold it in the form of gold ETFs since the price behaviour is exactly the same. You can actually buy low risk / low beta products through ETFs.
• ETFs are a good means of diversifying your risk. If you are holding on to a portfolio of stocks that are very vulnerable to dollar weakness then you can hedge the portfolio by purchasing Dow Jones ETFs which normally tend to benefit from a dollar weakness. This helps you to hedge your portfolio in a very efficient and economical manner.
• ETFs enjoy low expense ratios. Since they are indexed to an underlying asset, it is a passive form of investment and hence the active asset management effort is quite limited. Unlike mutual funds, the ETFs don’t have to incur huge marketing and registry costs. Due to no fresh inflows, the transaction costs of deploying are also very limited. It offers a good low cost option of participating in underlying indices.
• There are different taxation rules based on the underlying assets of the ETF. For example, an index ETF like the Nifty ETF or Sensex ETF is taxed in the same way as equities and equity mutual funds giving them the benefit of concessional taxation in case of long term and short term gains. Thus ETFs can be a low cost and an efficient method of participating in markets passively.

An ETF is a low cost and passive method of participating in an asset class like gold, silver, crude oil or equity and bond indices. Here are some categories of investors who should seriously look at investing in ETFs.

• For young investors starting off into equity investing, index ETFs may be a good place to start off with. You get a diversified portfolio of Nifty stocks and costs are very low which is likely to find favour even in tough market conditions
• Conservative investors looking to participate in a diversified portfolio of equities with low costs and low risk can also look at index ETFs. Since these ETFs only have market risk, the investors are not exposed to company-specific or industry-specific risk.
• Gold ETFs can be a necessary part of your overall portfolio, for gold investment that you do not propose to hold in jewellery form. Gold is a good hedge against geopolitical uncertainty and gold ETFs can be your answer to such a situation.
• Investors looking to participate in a short to medium term trend in a particular sector or a particular commodity class can also use specific ETFs as a useful option. You have sectoral ETFs and you also have ETFs linked to commodities like gold and crude oil.

- Trade like stocks

You can buy and sell an ETF during market hours on a real time basis as well as put advance orders on purchase such as limits or stops. In case of conventional mutual funds, purchase or sale can be done only once a day after the fund NAV is calculated.

- Low cost of investment

The passive investment style with low turnover helps keep costs low. ETFs are known to have among the lowest expense ratios compared to others schemes.

- Diversification benefit

In case of Nifty ETF, you own the complete basket of 50 stocks and remain diversified.

- Simple and transparent

The underlying securities are known and quantities are pre-defined (In case of conventional mutual fund schemes, one needs to wait for the monthly factsheet). No form filling is required if you transact in the secondary market. Investment can be made directly from the fund house or the exchange.

- Supports small ticket investments

ETFs are a great tool for investors wanting to start with a small corpus. The minimum ticket size is 1 unit (in case of IIFL Nifty ETF, 1 unit is approximately 1/10th of Nifty level, i.e Rs500, when Nifty is at 5000). Premium and discount also tends to be higher in the futures segment, than in ETFs.

- ETFs are taxed like stocks

nvestors can take advantage of special rates for short term and long-term capital gains.

- Target audience

Long term investors
First time investors
Investors looking for a low cost diversified portfolio
Traders who do not have enough capital to invest in index futures
Institutional investors looking to temporarily park cash during portfolio transition
Arbitrageurs to carry out operations with low impact cost

- Concept of tracking error

The extent to which the NAV of the scheme moves in a manner inconsistent with the movements of the underlying Index on any given day or over any given period of time due to any cause or reason whatsoever including but not limited to expenditure incurred by the scheme, dividend payouts if any, all cash not invested at all times as it may keep a portion of funds in cash to meet redemption, purchase price different from the closing price of securities on the day of rebalance of Index, etc.

- Points to note before investing in ETFs

- Invest in ETFs with ample secondary market liquidity

Fund houses do depend on market makers and arbitrageurs to maintain liquidity to keep the price in line with the actual NAV.

- ETFs track the target index

Any investor wanting an exposure to a particular target index like Nifty will do well by investing in ETFs. The objective of ETF is to be the index rather than beat the Index.

- Always invest in key benchmarks ETFs rather than sectoral funds

Investing in sectoral ETFs is prone to higher volatility compared to key benchmark ETFs like Nifty.

- Cost of trading on the exchange

Investor will have to bear the cost of brokerage and other applicable statutory levies e.g, Securities Transaction Tax, etc, when the units are bought or sold on the stock exchange.