ETFs, as the name suggests, are funds that are traded directly on the exchange and hence called exchange-traded funds. These are generally index-based products that do not require active management.
An ETF tracks an index of the asset as closely as possible to generate returns akin to the basket. In fact, the trading price of an ETF is linked to the net asset value (NAV) of the underlying asset that it represents. So, for example, if you consider a Gold ETF, its underlying asset is gold and the price of the ETF would vary according to the price of gold.
ETFs provide exposure to a basket of securities or commodities (gold/silver) or bonds traded on an exchange like a stock and traded in the form of units. While the basic character is the same as that of a mutual fund scheme that replicates the performance of the index, ETFs also have some features of an equity share.In India, most ETFs track NIFTY indices or the BSE Sensex and their variants.
An ETF is structured in as much the same manner as the unit creation of a mutual fund. The units can be bought or sold directly on any exchange trading platforms during the market hours daily. The trading on the exchange ensures that the price remains close to the NAV of the index being tracked. The difference between the return of the ETF and the index is referred to as a tracking error.
How Do ETFs Work?
ETFs provide investors with the opportunity to invest in a fund that mirrors the performance of a basket of securities (generally an index). Units of this fund can be bought or sold directly on the exchange. The price is determined by a willing seller and a willing buyer, like in the case of an equity share. The price of an ETF would therefore keep on changing during trading hours on the basis of the change in the price of the underlying securities.
In addition to ensuring that adequate liquidity is provided to the investors and also a fair price, there is a concept of a market maker. Market makers are designated brokers who provide a two-way quote — buy as well as sell — to not only provide liquidity but to also ensure that the transaction is executed at a fair price to the NAV and it is not at a huge margin.
Therefore, an ETF is bought and sold like equity stock the entire day during market hours of the stock exchange. It even has a ticker symbol, like a stock, and its price data is also easily available during the course of trading days.
Features of ETFs
Passive Management
There is no need to have a fund manager in an ETF, since the underlying basket is pre-determined at the time of creation. An investor is aware of what shares are part of the creation unit. The change would happen only when there is a change in the constituent of the Index.
So, for example, if an investor has invested in Nippon India ETF Nifty BeES, the underlying are the top 50 stocks which comprise the Nifty are in the portfolio. The only change which will occur is when there is a change in the composition of Nifty. The returns of ETFs that track the Nifty would be in line with the returns of the Nifty.
Tracking Error
The performance of an ETF is assessed on the basis of what is termed as Tracking Error. The tracking error is the deviation in the return of the ETF vis-a-vis the benchmark. When the tracking error is close to zero, it indicates that the ETF mirrors the index well, Irrespective of whether the error is positive or negative. A consistent positive tracking error means the ETF is apparently more efficient and vice versa.
Table 1 depicts the returns of 5 schemes along with the respective benchmark returns and tracking errors. The returns of ICICI Pru S&P BSE 500 ETF, Kotak NV 20 ETF and ICICI Pru Midcap 150 ETF are lower than their benchmark returns and the tracking error is low. ICICI Pru Midcap 150 ETF has the lowest tracking error of 0.04%. It means the ETF is replicating its benchmark index, i.e., S&P BSE 500, as closely as possible.
Table 1: Scheme returns and tracking errors
| ETF name | One year returns (%) | Benchmark returns (%) | Tracking error (%) | |||
|---|---|---|---|---|---|---|
| ICICI Pru S&P BSE 500 ETF | 16.65 | 16.97 | 0.04 | |||
| Kotak NV 20 ETF | 23.54 | 23.9 | 0.08 | |||
| ICICI Pru Midcap 150 ETF | 19.54 | 19.9 | 0.11 | |||
| Edelweiss ETF – Nifty Bank | 3.14 | 2.95 | 0.25 | |||
| Axis Banking ETF | 3.07 | 2.95 | 0.34 | |||
| (Data as on March 2, 2022; Source: Morningstar) | ||||||
Similarly, the returns of Axis Banking ETF and Edelweiss ETF – Nifty Bank are marginally higher but looking at the tracking errors, one can conclude that the ETFs are closely mirroring their respective benchmark, i.e., Nifty Bank index.
Low cost product
An ETF is a low cost product because it requires low monitoring. There are hardly any transaction costs and since there is no active fund management there is no cost involved in the stock selection. However, in addition to the cost of the fund the investor will need to bear brokerage on buy and sell in the same manner as an equity share.
Highly liquid
As an ETF is traded on a stock exchange, an investor can easily and conveniently invest and exit from it. An added advantage is that in case of volatile movements in the markets, an investor can take advantage of the same even during market timings which is not possible for an investor in a mutual fund. Moreover, in a mutual fund, an investor that exits the fund within one year normally has to bear an exit load, which is not there in case of an ETF.
Highly diversified
An ETF invests in almost the same proportion as the replicating index, so an investor gets to invest in multiple top companies that are part of an index. This diversification helps in mitigating the risk of investment in just one single investment.
Simple product
The core focus of an ETF is performance as per indices like Nifty, Sensex, BSE 100, Nifty 100, and Nifty Next 50. So, a novice investor does not have to worry about the investment style or analyze the past performance against the backdrop of down market or up market conditions.
Units of ETFs may trade at prices other than the NAV
There may be fluctuation in the trading prices of units of ETFs as per the changes in the NAVs of the securities held due to changes of securities market value or market supply and demand. An investor needs to ensure that the price is not too much at a variance to the NAV of the ETF.
Taxation
Taxation of ETFs is the same as that of mutual funds. So there is no difference where taxation is concerned.
Things to Keep in Mind When Investing in ETFs
As investing in ETFs is easy and convenient, most investors are choosing to invest in them. But before investing in ETFs, you must bear a few things in mind.
Do not treat an ETF like a stock
Although an ETF can be bought and sold like equity on an exchange, it should not be traded like one. Since the nature of an ETF is more like a mutual fund, intraday trading with an ETF is avoidable; invest for the long term.
ETFs will not outperform the market: An ETF is designed to perform in sync with its benchmark index. As it invests in almost the same proportion as the index, do not expect the fund to outperform the market. If the market falls, an ETF can give negative returns. Set realistic expectations while investing in ETFs and remember ETFs are not designed to outperform the market.
Check the ETF’s age
There is ample data available, especially on older ETFs. Analyze the historical performance before you invest but also remember, past performance is not indicative of future returns.
Note the tracking error
The tracking error has to be as close as possible to zero. If it deviates a lot from the tracking benchmark index, it indicates that the ETF is not investing as per the index.
Check the liquidity
Choose an ETF wisely based on how liquid it is, in terms of volumes traded on the exchange. Higher liquidity means it will have a lower bid-ask spread. It is one of the most important aspects you need to take into consideration before investing in any ETF.
Bottom Line
ETFs are an innovative investment tool, which are yet to catch up with their global investing trends in India. For instance, equity ETFs are good for investors who find it difficult to invest in stocks and want to begin investing in stock markets. international ETFs provide a gateway to investing in overseas markets and bring in diversification when added to a portfolio, while commodity ETFs are beneficial for hedging purposes.
