Introduction to Exchange Traded Fund (ETF)

In an ETF, the weight of all securities mirrors the weight of the securities in the underlying benchmark index.

May 26, 2021 08:05 IST India Infoline News Service

ETFs are types of Mutual Funds that aim to track the performance of a specific index such as NIFTY 50, NIFTY Next 50, NIFTY Bank etc. These ETFs can be based on indices tracking various asset classes like equity shares (NIFTY 50 ETF), bonds (10-year G-Sec ETF), Gold (Gold ETF), Tri-party Repo (Liquid ETF) etc.

In an ETF, the weight of all securities mirrors the weight of the securities in the underlying benchmark index. For example, if ABC Bank has a weight of 10.52% in NIFTY 50, a NIFTY 50 ETF will also have ~10.52% of ABC Bank by weight in its portfolio.

ETFs are called passive funds because the fund manager does not try to outperform the benchmark index but instead tries to mirror its performance. For example, a NIFTY 50 ETF seeks to generate return which is similar to NIFTY 50 Total return index.

Advantages of an ETF

The Exchange Traded Funds (ETFs) are:
  • Easy to Transact (Can be bought or sold on exchange)
  • Frugal (Low cost)
  • Transparent (Replicates the portfolio and return of stated index (subject to tracking error)

ETFs are an investment medium which combine the features of mutual fund & stock investing.

On one hand, investors can buy an ETF to get underlying Index returns at low cost (low expense ratio) and on the other hand they can trade in an ETF like a stock at live NAV, to benefit from intra-day volatility, if desired.

Why ETFs now?

With large cap funds finding it increasingly difficult to outperform benchmark indices like NIFTY 50, ETF provides a low-cost investment avenue to take exposure of various segments of the markets including large caps. Through investment in ETFs, investors may create wealth along with comfort of portfolio transparency and tradability like stock. ETFs are based on public indices and disclose their holdings on a daily basis, enabling investors to know what they are investing into on a regular basis.

How to trade in an ETF?

Transaction on Exchange

As the name implies, Exchange Traded Funds can be bought and sold on stock exchanges, just like stocks. For example, a NIFTY 50 ETF (An open-ended scheme replicating/tracking Nifty 50 Index) can be listed and traded on either or both National Stock Exchange (NSE) and Bombay Stock Exchange (BSE).

On the stock exchange, buy and sell trades for ETF units are usually carried out by:
  • Existing or new investors
  • Authorized Participants (AP) who act as a market maker by providing both buy and sell quotes, with some spread. Since AP provides these quotes based on intra-day indicative Net Asset Value (iNAV), the prices of ETF units remain close to their latest NAV throughout the day.
For example, Let’s say the closing NAV of a NIFTY 50 ETF on February 26, 2019 was 108.50. On the next trading day, if NIFTY 50 index moves up by 1% by 10:30 am, NIFTY 50 ETF will trade around in its iNAV (indicative NAV) on exchange which will also be higher by 1%, i.e. 109.585 at 10:30 am on February 27, 2019. The investor who wants to buy or sell ETF units from exchange (in multiples of one unit) can go to their brokerage account and trade in ETF units just like stocks.

Transaction directly with AMC or Authorized Participant

Large investors, who want to trade in multiples of creation unit size can also buy or sell ETF units from Authorized Participants (AP) or Asset Management Company (AMC), instead of the stock exchange, if desired. A creation unit is a portfolio which mirrors the composition of the underlying index and represents “x” amount of ETF units. For example, the creation unit of NIFTY 50 ETF will consist of 50 companies with similar weight as in NIFTY 50 Index and some minor cash component. A creation unit size of a NIFTY 50 ETF which has a NAV of 112 and consists of 50,000 ETF units will be Rs 56 lakh.

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