Exchange Traded Funds

Exchange Traded Funds (ETFs) have been in existence in India for quite some time now. But so far ETFs have not enjoyed the kind of popularity that the conventional Mutual Funds enjoy. One reason could be the lack of understanding of the concept of ETF amongst the general investor and also most people lack the awareness about the existence of such funds. In this post, let us understand what are exchange traded funds, how they work, their pros and cons.

What are ETFs?

As the name suggests, ETFs are a mix of a stock and a MF in the sense that 

·         Like mutual funds, they comprise a set of specified stocks e.g. an index like Nifty/Sensex or a commodity e.g. gold; and

·         Like equity shares they are traded on the stock exchange on real-time basis.

How does an ETF work?

In a normal fund we buy/sell units directly from/to the AMC. First the money is collected from the investors to form the corpus. The fund manager then uses this corpus to build and manage the appropriate portfolio. When you want to redeem your units, a part of the portfolio is sold and you get paid for your units. The units in a conventional MF are, therefore, called in-cash units.

But in ETF, we have something called the authorized participants (appointed by the AMC). They will first deposit all the shares that comprise the index (or the gold in case of Gold ETF) with the AMC and receive what is called the creation units from the AMC. Since these units are created by depositing underlying shares/gold, they are called in-kind units.

These creation units are a large block, which are then split into small units and accordingly bought/sold in the open market on the stock exchange by these authorized participants

Therefore, technically every buy and sell need not change the corpus of an ETF unlike a conventional MF.

However, as and when there is more demand, these authorized participants deposit more shares with the AMC and get more creation units to satisfy the demand. Or if there is more redemption, then they give back these creation units to the AMC, take back their shares, sell them in the market and pay the investor. 

All this may seem to be a bit complicated and time-consuming. But, in effect, it is all system driven and hence happens on real-time basis with minimal effort & cost.

Benefits of investing in ETFs

·         Convenient to trade as it can be bought/sold on the stock exchange at any time of the day when the market is open (index funds can be bought only at NAV based on closing prices)

·         One can short sell an ETF or buy on margin or even purchase one unit, which is not possible with index-funds/conventional MFs

·         ETFs are passively managed, have low distribution costs and minimal administrative charges. Hence most ETFs have lower expense ratios than conventional MFs

·         Not dependent on the fund manager

·         Like an index fund, they are very transparent

Disadvantages of investing in ETFs

·         SIP in ETF is not convenient as you have to place a fresh order every month

·         Also SIP may prove expensive as compared to a no-load, low-expense index funds as you have to pay brokerage every time you buy & sell

·         Because ETFs are conveniently tradable, people tend to trade more in ETFs as compared to conventional funds. This unnecessarily pushes up the costs.

·         You can’t automatically re-invest your dividends. Secondly, you may have to pay brokerage to reinvest dividends in ETF, whereas dividend reinvestment in MFs is automatic and with no entry-load

·         Comparatively lower liquidity as the market has still not caught up on the concept

It may, therefore, be concluded that if an investor is looking for a long-term and defensive investment strategy in equities by backing the index rather than looking at active management, ETF offers an alternative to index-based funds. It offers trading convenience & probably lower costs than index funds. A case-to-case comparison is, however, important as some index-funds may be cheaper. Also for SIPs, index-funds may prove better than ETFs.

However, in the absence of conventional MFs like in Gold, ETFs is but a natural and better choice than buying/selling physical gold.