Preface to ETF

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Also referred to as exchange traded funds, ETFs are slowly gaining momentum among Indian investors. Because of their ability to offer dual benefits of stock and mutual funds, ETFs are among the most favored investment instruments in the country. Exchange traded funds can be considered by individuals who are looking to invest in a scheme that generates returns without human fiddling. These investments can be both for the short term as well as long term as investors can indulge in intraday trading with exchange traded funds.

An exchange traded fund is a one-of-a-kind mutual fund scheme that is listed at almost every stock exchange and whose units can be bought and sold for their live market price just like company stock. The investment objective of an exchange traded fund is to generate returns close to its underlying benchmark with minimum tracking error. These funds invest a minimum of 95% of their total assets in the underlying index that they are tracking.

What are the different types of exchange traded funds?

Exchange traded funds work pretty much like any other type of mutual fund scheme. They pool financial resources from investors sharing a common investment objective and utilize these resources to buy tradable securities like stocks, bonds, etc. As of now, these are the five broad categories available in India –

Index ETFs – An index ETF invests its entire investible corpus in the securities of an index in the same composition as they are listed on the index. These funds usually track benchmarks like NIFTY50, SENSEX30, etc.

Gold ETFs – These funds invest in gold bullion and usually track the domestic price of gold as its benchmark.

Bond ETFs – Bond ETFs invest in debt related instruments and fixed income securities like bonds, debentures, etc.

Sectoral/Thematic ETFs – Sectoral and thematic ETFs are benchmarked to an index that comprises stocks belonging to a particular sector or theme, e.g., the NIFTY Commodities Index.

International ETFs – International ETFs may either directly invest in foreign securities or they may invest in funds that are listed on foreign indices and are often sponsored by the parent AMC based out of a foreign country.

How does an Exchange Traded Fund work?

Exchange traded funds are traded just like company stocks – through creation blocks. As they invest in a pool of diversified stocks that comprise a benchmark, they possess the characteristics of both a mutual fund as well as a stock. Investors can buy and sell ETF units at any given time during live trading hours at the fund’s market price that fluctuates throughout the day. The Net Asset Value of an ETF depends on the performance of its underlying securities. So when the stocks that comprise a particular ETF are performing, the NAV of the ETF will go up and vice versa.

What are some of the unique features of ETFs?

ETFs adopt a passive style of investing. This is different from the otherwise commonly invested active mutual funds where the fund manager is the decision maker and solely responsible for ensuring that the scheme is able to beat its benchmark and generate returns better than its peers. When it comes to ETFs, they are designed to replicate returns close to their index. The fund manager does not buy or sell securities to generate returns and is only involved in ensuring that the scheme’s portfolio composition remains aligned with that of the index. Since there is not much active involvement in passive ETFs, they carry a low expense ratio thus making them a cost-effective investment.

However, investors need to have a DEMAT account to trade in exchange traded funds and there are also transaction costs involved every time you buy or sell your ETF investments.