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Exchange Traded Funds(ETFs)

What is an ETF?

Exchange traded funds (ETFs) are closed ended funds that are listed on a stock exchange. They can be bought and sold on a recognized stock exchange and the ETF units can be held in your normal demat account. ETFs track an index like the Nifty, Sensex or global indices. You can also invest in ETFs that are backed by commodities like gold, crude oil etc.

What are 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.

How are ETFs created?

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 to invest in ETFs?

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.

Why should you invest in ETFs?

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.

Who should invest in ETFs?

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.

The ETF advantage

- 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.

What happens in case of default on payment or delivery of ETF's?

ETFs, for all practical purposes are exactly like shares. They are listed and traded on the stock exchanges and the rules for delivery and margin payment are also exactly the same as in the case of equities. Normally, when you buy an ETF, the broker will ask you to pre-fund the trading account. If your account is still not funded till the end of the day, the broker will urge you to deposit the full amount latest by next day (T+1) morning 10.30 am. If you are unable to pay the amount by that time then it becomes a default.

Can ETF units be used for paying margins to the Stock Exchange?

Traders and investors need to make two kinds of payments to their brokers. Firstly, there is the margin which you pay as a percentage of the total value in case you are going for intraday trading or trading on margins that is funded by the broker. Such funding is normally done by the NBFC arm of the broker since SEBI regulations do not permit the broker to fund a client account. In the case of intraday trading, the margin can be paid either in the form of cash or in the form of stocks / ETFs.

However, it needs to be remembered that while you will get the full value of the cash deposited as margin, you will only get the partial value (after a haircut) in case of assets like equities and ETFs. The norm is to give you margin to the tune of 50% of the value your shares and ETF holdings. However, since ETFs are less volatile and less vulnerable to sudden price shifts, you can negotiate with your brokers for a lower haircut so that you can get margins to the tune of 60-65% of the value of the ETFs deposited by you. Remember, these are only for intraday trading and you are required to close out the margin position on the same day. If you do not close the position by 3.00 pm in the afternoon, the broker’s RMS will automatically terminate all open intraday positions. In case the position is somehow missed out, the broker will make a margin call to pay up the balance to the exchange. If you are unable to pay then the broker has the leeway to sell your pledged ETFs and realize the dues.

What are the applications of ETFs?

ETFs may appear to be a plain vanilla product but there are some interesting applications apart from just taking a macro view on an index or a commodity. Here are a few of them.

  1. ETFs provide permit a convenient way to participate in the market via indices. After all, Nifty and Sensex have done well in the last many years since inception. The investor can take specific views on commodities, indices or even sectors and bond indices.
  2. ETFs can be a good way to park temporary surpluses, both for individual investors and also for institutions. Investors with idle cash in their portfolios may want to invest in a product tied to a market benchmark like an index as a temporary investment and this can be a good low cost method.
  3. ETFs, especially index ETFs, are agnostic products where the investor can be indifferent to the actual stock selection. Investing in shares tied to an index or basket of stocks provides diversified exposure and also saves the investor from unsystematic risk.
  4. There are lot of sectors where there may not enough expertise or information available to you. In such cases, the ETFs offer a lost cost and also a low risk method of participating in the particular theme. It can also be used to underweight or overweight in a particular sector.
  5. 5.ETFs in India do not permit short selling, except for intraday. However, one can take contrary positions by selecting an appropriate index. For example, one can hedge equities against market volatility by buying gold ETFs.

What is the difference between ETFs and Futures?

In a sense, ETFs are also derivative products since they derive their value from an underlying asset like an index, commodity or bond index or even sector. Even futures are a derivative on an underlying like the stock or the index. Are futures and ETFs the same? There are some subtle differences.

  • Futures are leveraged but ETFs are not exactly leveraged. For example, in futures, you can take a position worth Rs10 lakhs by paying a margin of say Rs2 lakhs. Profits can multiply and so can losses. ETFs can be fractional units but the risk of losses multiplying does not exist in ETFs. It is more of a linear 1-on-1 relationship.
  • Futures can be played both ways; you can go long on index futures and you can also go short on index futures based on your view on the index. ETFs can only be purchased or they can be sold for intraday. You can sell short sell futures and carry forward the short sell positions in India.
  • Index Futures are contracts. That is why index futures do not get into your demat account but stay in your trading account. ETFs, on the other hand, are actual assets created out of an underlying. They can hold as assets in y our individual demat account with a broker.
  • Futures being contracts have a fixed expiry. Normally, index futures expire on the last Thursday of the month. At appoint of time you have 3 contracts on futures viz. Near Month, Mid Month and Far Month. In case of ETF, there is no such contract specification and you can actually buy and hold these ETFs for as long as you can.

Should I invest in ETFs or index funds?

Both ETFs and index mutual funds are an indirect position on the index. They represent a common approach to buying the entire market via an index rather than getting into stock selection. The choice would be based on your specific needs but here are some key differences between index funds and ETFs.

  • ETFs are closed ended while index mutual funds are normally open-ended. That means index funds can be purchased and sold on tap at the daily NAVS announced by the fund. The ETFs used the underlying price as the benchmark but the price of the ETF fluctuates in the market with the underlying price of the index or commodity.
  • ETFs don’t create volatility in the fund because any buyer has to be backed by a seller. There is no impact on the corpus of the fund. In case of index fund, it is different. When there are inflows, the corpus of the fund increases and the surplus has to be invested. When there are outflows, the fund has to keep liquidity sufficient to meet the redemption requests. Thus index funds tend to be more volatile due to liquidity management, compared to ETFs.
  • An index fund has to constantly be churning its portfolio to ensure that the overall corpus of the fund reflects the index as close as possible. This results in higher impact costs in the case of index funds. In the case of ETFs, the fund manager does not have to worry about handing regular inflows or outflows since it is closed-ended. This makes the tracking error substantially lower in case of index ETFs.
  • Both index funds and ETFs are passive approaches and do not require active management. However, the costs in case of ETFs are far lower since you do not need too much of fund management to keep the tracking error in check. Also, the administrative costs are much lower in the case of ETFs as the registry costs and the marketing costs are also relatively lower. This works in favour of ETFs in the long run.

What are the benefits of ETFs?

In India, ETFs are more popular among retail investors rather than the institutional investors. Globally, ETFs are also quite popular among institutional investors and hedge funds. Here are some of the key benefits of ETFs.

  • You can take a position in a market or a commodity with a single click. By purchasing an index ETF or gold ETF, you participate in all the features of the commodity in one shot.
  • ETFs are highly cost effective considering that they do not require too much of active management. Also, being closed ended; they entail lower levels of track error management compared to other passive methods.
  • ETFs on indices are treated as equity funds for income tax purposes. Hence, such index ETFs is the beneficiaries of concessional rate of taxation on dividend distribution and also in case of long term and short term capital gains.
  • ETFs are highly flexible as an investment option. You can take position in indices and commodities at any time during the day and either adopt a directional view or a hedge against your existing positions.
  • ETFs are extremely transparent. There is a reputed AMC, a board of trustees, a custodian bank that certifies the back-up holding and the oversight of SEBI. All these factors make the product safer for retail investors in India.
  • ETFs being closed ended funds, the dividends are automatically reinvested back into the fund and thus helps the power of compounding work in your favour. This is useful when it comes to long term wealth creation through a passive approach.
  • ETFs are very simple as a product. Even a layman can understand that when you buy an ETF you participate either in a commodity or in a benchmark index. Also, these ETFs are traded real time on the screen and that also builds confidence that the market mechanism will take care of the rest.