Exchange Traded Funds(ETFs)
What is an ETF?
ETFs are essentially index funds that are listed on an exchange and track the price performance of the target index closely. The ETF trading value is based on the net asset value (NAV) of the underlying stocks in the target index. E.g., a Nifty ETF will look to replicate CNX Nifty returns.
ETFs are popular world over with nearly 60% of trading volumes on the American Stock Exchange (AMEX) captured by all types of ETFs. At the end of June 2011, the global ETF industry comprised 2,825 ETFs from 146 providers on 49 exchanges around the world with total assets of US$1.49 trillion (Source: www.ifaonline.co.uk).
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- Investors can take advantage of special rates for short term and long-term capital gains.
- 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.