ETFs – Know all about them

Over the past few years, Indian investors, including High Networth Individuals (HNIs) as well as Ultra High Networth Individuals (UHNIs), have begun looking at passive investment as a viable alternative to active investing.

While passive investing has long been the preferred route taken by retail investors across developed economies like the US and Europe for the past few decades, it has now begun taking root in India.

Apart from passive mutual funds as well as index funds, Exchange Traded Funds or ETFs are emerging as one of the best options for capital markets.

What are ETFs?

But first things first, what exactly are ETFs? ETFs are basically funds that hold a basket of stocks, but which are actively traded on stock exchanges, just like shares.

These funds typically pool money from retail and institutional investors and invest the same in diversified securities ranging from stocks to bonds and from commodities to gold. Effectively, ETFs track an underlying index say like the Nifty or the Sensex or even a sectoral one like the Bank Nifty.

The various indices are tracked by buying shares in the same proportion as the weightage assigned by to them in the underlying index the ETF is tracking.

The main difference between an index mutual fund and an ETF is that unlike the former, the latter is held in a customer’s demat account and can be traded during active market hours, unlike mutual funds.

What are some of the advantages of investing via the ETF route?

ETFs offer several advantages over mutual funds and other passive investment avenues.

Some of the advantages offered by ETFs are:

Low cost 
In India, ETFs have expense ratios as low as 0.5%. This is a significant advantage as it lowers the cost of these funds in the long term, especially when a wealthy investor is looking to put a significant amount of money to work in the stock market.

Liquidity

ETFs are tradable on the stock exchanges and can be bought and sold in real time, just like stocks. This means that they offer a higher degree of liquidity as compared to mutual funds.  

Diversity

ETFs track varied indices such as Nifty, Sensex, the Bank Nifty, Gold, bond indices, low volatility indices etc. This makes them one of the most diverse investable instruments bring offered in the market right now.

Transparency

As ETFs track known indices, the stocks, bonds and other securities they hold are well known. Moreover, the proportion in which these securities will be held, are also known. This affords a great deal of transparency to the investor as he or she is aware of where exactly their money is being invested.  

Passivity

As these are passive instruments, there is no manual intervention. The investments are regulated by predefined algorithms with little chance of a tracking error creeping in. This also means that fund manager risk is next to nothing as the intervention is bare minimum.  
 

Disadvantages of ETFs

Having said that ETFs also have some disadvantages or limitations.

They rarely outperform the market

Since these are passively managed instruments tracking an underlying index, they cannot outperform their peers or the market in general. This is where an actively managed fund scores over an ETF as the fund manager can try and choose a basket of stocks that can possibly outperform the sectoral or broader market index, thereby generating alpha.

Need a demat and a trading account

Unlike direct mutual funds that can be bought directly from the fund house, an ETF can only be held in a demat account. To trade the ETF one also needs a trading account. So, if one wants to invest via the ETF route, a demat and trading account are mandatory.

Limited growth 
ETFs mostly track indices which are made up of mature companies that are well established and already have enough scale.

Types of ETFs

The Indian ETF market is yet maturing. But even as it grows, it is diversifying across asset classes such as equity, debt, gold and currency markets, which are tracked by a few well known ETFs.

Equity ETFs

As the name suggests, they invest in shares of companies that form the underlying of an index. Some of top equity ETFs in terms of returns in India are

Gold ETFs

These are basically commodity ETFs that track the movement in the price of gold. They basically hold shares of companies that own physical gold as an underlying asset and their NAVs fluctuate basis the price of gold. Thus, they do not necessarily have to own gold and can operate independent of the risk of asset protection. 
 

Debt ETFs 
As the name suggests these ETFs invest in debt instruments like fixed income securities such as bonds, debentures etc. This is why they are also called Bond ETFs.

Currency ETFs

These try and generate alpha from exchange rate fluctuations. They invest across different currencies based on global market conditions and predictions on how those currencies are likely to perform in the future.

A couple of such ETFs that investors can consider include the Wisdom Tree Indian Rupee Strategy Fund and Market Vectors- Indian Rupee/USD ETN.

Conclusion

HNIs and UHIs can consider investing in the stock market via the ETF route as they are low-cost instruments that offer flexible trading, a chance at diversification of portfolio and higher a high level of transparency. The Indian ETF market is still quite small compared to say the US but it is growing fast.

FAQs

1) Are ETFs a popular investment choice?

ETFs are becoming popular among investors who had preferred active fund investments as they provide access to a variety of asset classes across different industries, and international markets. To be sure there are also some risks attached to ETFs that investors must carefully study before making an investment.

2) What is the downside of ETFs?

Tracking error is one major drawback of ETFs as it can add to the overall cost for investors. Different ETFs may carry different levels of tracking error. Since ETFs mostly track an index performance, the fund’s returns may have lower chances of outperforming the index.

3) Are ETFs good for beginners?

As long as investors study the composition of the index chosen ETFs can be a good choice for all.