What is an ETF?

Ravi, Sunita and Sumeet can use an Exchange Traded Fund (ETF). ETF is a Mutual Fund scheme which is listed and traded through the stock market platform. But let us begin with understanding what an ETF is.

An Index Fund is an open-ended mutual fund that endeavours to replicate the performance of it’s underlying index (subject to expense ratio and tracking error). In other words, it’s portfolio tends to mirror it’s underlying index constituents by holding the securities in the similar propotion as their weightage in that index.

ETFs are also open-ended funds and can also be traded like stocks on the exchange(s).

For example, there may be an ETF on Nifty or S&P BSE Sensex, whose portfolio will be exactly the same as the index. It will hold all the securities in the same weightage as in the index.

ETF Scheme Return = Market Return*

(*subject to ETF expense ratio and tracking error)

Since the ETF mirrors the performance of the index, it makes no attempt at forecasting and analysis of companies and stocks. This is called passive investing. Thus, the performance of ETF would rise or fall in accordance with the rise or fall in the benchmark index. No more and no less.

An Equity ETF, therefore, serves Ravi’s purpose of consciously avoiding the risks of active investing, where the returns will depend on the fund manager’s ability and timing to pick stocks/sectors. While it will provide equity-oriented returns using the index, the risk of underperformance is minimised vis-a-vis the broad market index.

Trades Like a Stock

As opposed to a conventional mutual fund, ETF is listed and traded like shares on a stock exchange through a trading account. Just like a stock, an ETF has a ticker symbol and follows the same settlement cycle.

It has an indicative real-time NAV (market price) as compared to only a single end-of-day NAV for traditional mutual fund schemes. The indicative NAV of an ETF changes in tandem with the change in its benchmark index value.

Diversify Across Asset Classes

Sunita can easily create a diversified portfolio using ETFs across asset classes and the best part is that she need not be an expert to be able to achieve that. All she needs is to buy the different ETFs and let each one replicate its respective market index or asset classes.

With ETFs, Sunita will find it is easy to move money between specific asset classes such as equity, commodities and fixed income.

Don’t Overlook Costs

The cost of running an ETF is usually lower than a conventional mutual fund. This is mainly because unlike the other mutual funds, the fund manager doesn't actively manage the ETF, and thus takes a smaller fee. This helps to keep the costs down for Ravi, Sunita as well as Sumeet. Operational and client servicing costs are lower as they are handled by the demat service provider or the broking house. Further, there is no exit load levied by an ETF.

Alternative to Futures

Speculative investors, who want to bet on the performance of the index, love ETFs for their flexibility and convenience. ETFs can be purchased in smaller sizes. They also don't require special documentation, special accounts, rollover costs or margin. Furthermore, some ETFs cover benchmarks where there are no futures contracts.

ETFs can be short-sold intra day and squared off like a stock. Additionally, ETFs can be short-sold for a longer duration by borrowing ETF units in Securities Lending and Borrowing (SLB) scheme.

Different Kinds of ETFs