What are ETFs and How it is different from mutual funds?

As an investor, you must have heard about the term ETFs and how it helps in achieving diversification of your investment portfolio.

And, you must be wondering, what are ETFs and how does it differ from other investment instruments?

This article will give you an overview of ETFs, benefits, disadvantages and how it is different from mutual funds. So, let’s begin.

What is an ETF?

ETF or Exchange-Traded Fund involves a group of securities- stocks, bonds, commodities which is listed on an exchange and lets you buy & sell it through your broker. An ETF usually tracks an underlying exchange or a sector or uses various investment strategies.

Let’s check this with a few examples of ETF to have a clear understanding:

CPSE ETF: The ETF invests in 12 state-owned companies that are part of the Nifty CPSE Index.

SBI- ETF Gold: It invests in gold and gold-related instruments and its main objective is to track the price movement in gold. The units can be bought through the National Stock Exchange, just like any stock.

HDFC- Sensex ETF: It aims to provide returns by investing in securities as represented by the Sensex.

You should think of ETFs just like a mutual fund, which can be bought and sold in real-time and its price changes constantly based on the value of underlying stocks it constitutes.

A brief history of ETF

The first ETF was launched on January 22nd 1993 in the US market, which was the S&P 500 Trust ETF (also called SPDR or spider in short). It is still the most actively traded ETF in the market even after 25 years of launch and expansion of the market.

ETFs are now one of the most popular investment instruments for both individuals and institutional investors. Globally, there are now close to 7,797 ETFs traded with a total asset under management of around $5.78 trillion as of September 2019. And, the US with almost 70% market share.

In India, the first ETF was launched on January 8th, 2002 and that was NIFTY BeES (Benchmark Exchange-Traded Scheme) which invests and tracks the performance of companies that are part of the Nifty. Currently, there are 71 ETFs traded in India benchmarked to various equity and debt indices and total asset under management stands at Rs 1.5 lakh crore at September end.

Now, let’s understand how ETFs are constructed.

Creation and Redemption of ETFs

Compared to mutual funds, the ETFs have a different working structure and are created through “creation/redemption” mechanism. Let’s understand the process:

  • When a fund house decides to launch an ETF, it approaches an authorised participant (AP), who is generally a market maker, a specialist or a large financial institution, having huge buying power.
  • The job of the AP is to acquire stocks that the ETF wants to hold. For example, if the ETF is designed to track Sensex, then AP will acquire the stocks in the same weight as it is represented in the index.
  • The AP then transfers the share to the fund house, who in turn will give ETF units of equal value to the AP, called creation unit. The exchange takes place on a one-for-one, priced at the net asset value.
  • Once, the AP receives all the ETF units, they are sold and listed just like any other stock.

All the stocks that are used to form a creation unit are held by the trust, specially created for the purpose. The only task of the trust is to provide administrative oversight and transfer of dividend amount to the ETF provider.

The redemption process is completely reverse of the creation process. This is when AP buybacks the ETF shares to form a creation unit and exchange it for a redemption basket of securities or cash. Generally, the redemption is done, when the ETF is trading at a discount to its underlying value. That is when AP may buy the ETF shares and sell the underlying securities,

In the same way, the creation process ensures the fair value of an ETF when it is trading at a premium to its underlying value.

Advantages of ETFs

Lower Costs: Since ETFs are passively managed, it has a much lower expense ratio compared to actively managed mutual funds. And, as they are traded on an exchange, expenses such as distribution cost, marketing fees, management fees are all eliminated.

Liquidity: One of the major benefits of an ETF is that it is traded like stocks, which helps in ensuring liquidity and enables real-time trading. This is an important benefit when volatility is high.

Transparency: ETF funds are more transparent than mutual funds, as the fund house in charge of the ETF cannot tinker with weightage of different stocks in the portfolio. And, in mutual funds, the portfolio is updated once a quarter. 

Diversification: ETF provides instant diversification as it gives exposure to a different group of securities, sectors, and investing style. It also helps in effective risk management through the reduced effect of volatility.

Trading flexibility: Unlike mutual funds, which are traded once a day after the market hours and announcement of the NAV. On the other hand, an ETF can be bought and sold when the market is open. The pricing of ETFs is continuous during the market hours. And, there is no minimum holding period in ETFs.

How to Invest in an ETF?

There are certain factors, you should look after before investing in an ETF and it is very similar to that of mutual funds.

Investment objective: The ETF should have a clear and well-defined investment objective, stating its investment approach, sector concentration, etc. 

Risk: Like all investments, ETFs are also subject to market risk and you should understand the different risk factors associated with the ETF. For example, if it is a banking ETF or gold ETF, then you should be well aware of all the risk factors associated with the sector. ETFs which show higher volatility in comparison to underlying assets in the portfolio should be avoided. 

Costs:  Generally, ETFs have a lower cost compared to mutual funds, but you should always check the costs associated with managing the ETF. You should also check the tracking error, which is the divergence in total return compared to total return that of benchmark or portfolio. It is reported as the standard deviation percentage. 

Total assets under management (AUM): It is an important metric and you should always choose an ETF with higher AUM, as it will lower the chance of liquidity risks. It will also help in reducing the risk of running mismanaged and unprofitable funds.

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