To say the least, an exchange traded fund is a mutual fund scheme. Still, there are certain aspects about this fund that distinguishes it from other mutual fund schemes. Since passive funds are slowly picking interest among Indian investors year are year, it is essential to understand more about exchange traded funds so that you have a fair idea about how they are different from other mutual funds, what investment and asset allocation strategy they follow, and whether they are ideal for your investment needs.
What are Exchange Traded Funds?
An exchange traded fund is a mutual fund scheme whose units are available for trading at their live market price at the stock exchange. Just like you buy and sell shares of a publicly listed company, you can similarly trade with exchange traded fund units. Hence the term ‘exchange traded’. ETFs are listed at almost every stock exchange thus making them accessible to aspiring retail investors. These funds try to generate capital appreciation by investing a minimum of 95 percent of their investment portfolio in the underlying securities that comprise an index/benchmark.
How does an Exchange Traded Fund work?
Affluent AMCs and fund houses create ETFs by pooling financial resources from investors sharing a common investment objective through the NFO (New Fund Offer). The fund manager builds a portfolio comprising of securities belonging to one specific index. For example, if an ETF is tracking the top 30 companies that comprise the SENSEX 30, you cannot expect that fund to hold stocks of companies listed on the NIFTY 50 index. Investors can indulge in intraday trading as well. So taking the above example, if you hold units in an ETF that tracks SENSEX 30 if the value of this index goes up so will the value of your ETF. Thus, you can sell your ETF units and book profit.
How are ETFs different from Mutual Funds?
You must be wondering ‘If ETFs are mutual funds, what’s the difference?’ Well for that you first need to understand the difference between active mutual funds and passive mutual funds. Active mutual funds are those mutual funds where the fund manager is the decision maker and responsible for ensuring that they trade with the underlying securities to generate returns for its investors. He is entirely in control of the investment portfolio of the mutual fund scheme and decides which stocks to buy/hold/sell. In the case of passive funds like ETFs, although there is a designated fund manager allotted, he/she has very little say in how the ETF scheme will generate returns. ETFs are designed in such a way that they try to mimic the performance of their underlying benchmark with minimal tracking error, unlike other mutual funds that are constantly striving to outperform the returns generated by their underlying benchmark.
Also, to trade in ETF units you need to have a trading account as well as a Demat account. When you buy ETF units, they are parked in your Demat account. However, to buy or sell mutual fund units you do not need a Demat account. You can either do it from a mobile app made available by the mutual fund aggregator or any of the SEBI registered entities through whom you are carrying out your transactions. Also, ETFs are more liquid than mutual funds. To buy or sell mutual fund units you need to place a request to the AMC and the transaction happens based on the NAV which is determined at the end of the day. But in the case of ETFs, investors do not have to wait for the NAV to be determined as their units are available for trading at their live market price.