Exchange Traded Funds (ETF): Meaning, Types and Benefits

In the last chapter, you learned about how mutual funds work and how you derive the NAV of a mutual fund. But do you know a fun fact about NAV in mutual funds? Usually, the NAV of mutual funds is updated by 11:00 PM on a trading day.

So, if you place your mutual fund order before the cut-off time, i.e. 3:00 PM, you will get the units as per the NAV on the same day before midnight. But if you place the order after the cut-off time, even on the same day, you will get the units as per the NAV of the next day, which will be disclosed at midnight of the next day. 

So, if you’re placing a large order to buy a mutual fund, the slight change in NAV may affect your returns in the short run. But what if you could buy and sell mutual funds in real-time, during market hours?

Well, ETFs are the answer to that! 

What is an ETF (Exchange Traded Funds)?

An exchange-traded fund (ETF) is a basket of different investments, kind of like a mix of stocks, bonds, or sometimes commodities. Investors buy units/shares of this basket, which represents a portion of all those different underlying investments inside. 

It is exactly like mutual funds, but ETFs are traded on the stock market just like individual stocks, making it easy for investors to buy or sell them throughout the trading day. They're popular because they offer diversification at a low cost and flexibility to investors without buying each investment separately.

Let's get a basic understanding of ETFs and how they differ from mutual funds before diving into how they work.

History of ETFs

Back in 1990, the first-ever Exchange-Traded Fund (ETF) was introduced by Canada. It was called the Toronto 35 Index Participation Units, which tracked Canada's major index, the Canada Stock Market Index (TSX).

3 years later in the USA, another ETF was introduced called the S&P 500 Trust ETF, often known as SPDR. Many years later, SPDR remains one of the most popular ETFs globally. As of March 2022, it boasted an impressive AUM (assets under management), totalling $455.22 billion. It's interesting that today, it's actually the most traded security worldwide. 

In India, the first ETF tracking the Nifty 50 index, called NiftyBeES, came out in 2002. It was originally launched by Benchmark AMC, which later went through a series of acquisitions until it ended up under the management of Nippon India Mutual Fund.

ETF Market and Growth in India

ETFs have been around in India for a while but haven't caught on with regular investors. Usually, high-net-worth individuals (HNIs) and big institutions dive into ETFs. Take the SBI Nifty 50 ETF, for instance; it's the largest ETF in India, largely because the Employees' Provident Fund Organisation (EPFO) invests heavily in it. 

Even so, investors face issues with volume buying and selling ETFs. Currently, there are 89 active ETFs available in the market.

The growth of ETF Assets Under Management (AUM) in India has a lot to do with EPFO investing in Nifty and Sensex ETFs, government divestment through CPSE and Bharat 22 ETF, and the introduction of Bharat Bond Debt ETFs pushed by the government. However, most of the AUM in these ETFs comes from non-retail sources.

Even though retail involvement is still relatively small, it has steadily increased over the years, along with trading turnover on the exchanges.

NiftyBeES, which has been around for more than 20 years, has an AUM of about ₹19,300.8 crore as of December 31, 2023. In late October 2023, the assets under management (AUM) for equity-focused ETFs in India reached ₹4.5 trillion, whereas debt ETFs managed about ₹90,130 crore. However, the ETFs have an AUM of only 10% of the size of mutual funds AUM. Whereas in the US market, the ratio is almost double. So there are several reasons why ETFs aren't as popular in India:

• Size of the Market:

Unlike mutual funds, you can only buy an ETF with a demat account. However, India's market is still relatively small, with only about 12.7 crore active demat accounts. 

• Push Products:

Whether mutual funds or ETFs, investment products usually need a push. Mutual funds are more significant than ETFs partly because Asset Management Companies (AMCs) can pay distributors and platforms commissions to sell their mutual funds. ETFs, on the other hand, don't have these commissions.

• Low Margins:

Most AMCs don't actively promote ETFs because they come with lower margins and may not make sense for them, especially when dealing with small AUMs.

How Does an ETF Work?

When you buy a unit of mutual fund, you're giving money to a team (AMC), who then buys stocks and/or other underlying assets and discloses the total value of your investment at the end of the day.

Now, think about stocks and how you can buy them on the exchange. ETFs work in a similar fashion when it comes to trading them. You can buy and sell them on stock exchanges during trading hours. You don't directly deal with the AMC. 

So, when you buy an ETF, it's like getting a share of the underlying assets. When you sell your ETF shares, it's like passing on your share of the ETF to someone else in the market.

Types of ETFs

Exchange-Traded Funds come in various types that cater to different investment goals. Let's break down some popular options available in the market:

• Passive and Active ETFs:

ETFs can be either passive or actively managed. Passive ones aim to mirror an index's performance, like the Nifty 50 or Sensex. On the other hand, actively managed ETFs involve portfolio managers making decisions about which securities to include, offering more control but usually at a higher cost.

• Bond ETFs:

These ETFs provide regular income to investors. You can invest in government bonds, corporate bonds, and municipal bonds. Unlike traditional bonds, ETFs don't have a maturity date and can trade at a premium or discount.

• Stock ETFs:

These types of Stock ETFs comprise a basket of stocks tracking a specific industry or sector. You get diversified exposure to industries like automotive or foreign stocks, offering growth potential at lower fees than mutual funds.

• Industry/Sector ETFs:

These ETFs focus on specific sectors or industries, like energy or technology. You can tap into sector growth without directly owning individual stocks. They are handy for navigating economic cycles.

• Commodity ETFs:

These ETFs invest in commodities such as crude oil or gold, providing diversification to a portfolio. You can invest effectively compared to the physical possession of commodities and act as a cushion during market downturns. 

• Currency ETFs:

Such ETFs track the performance of currency pairs, offering a way to speculate on currency prices or hedge against volatility. Some are also used to hedge against inflation.

• Bitcoin ETFs:

These ETFs are a recent addition approved by regulators in the US, allowing investors to gain exposure to Bitcoin's price moves without owning the coins. You can directly invest in bitcoins or use futures contracts. You will save 30% on taxes on capital gains of bitcoins.

• Inverse ETFs:

Such ETFs aim to profit from stock declines by shorting stocks. They use derivatives to achieve this and are essentially bets that the market will decline. You should be cautious, as some are exchange-traded notes (ETNs) rather than true ETFs.

• Leveraged ETFs:

These ETFs seek to amplify returns, for example, 2× or 3×, based on the underlying investments. They use derivatives like options or futures contracts. Be aware of the increased risk associated with leverage.

Benefits of ETFs over Mutual Funds

Remember, both ETFs and mutual funds have their place, and the best choice depends on your investment goals and preferences. It's like choosing between different dishes – what suits your taste might not be the same for someone else.

• Flexibility in Trading:

ETFs are like stocks, and you can buy or sell them on the stock exchange throughout the trading day at market prices. It's like grabbing a snack whenever you feel hungry. On the other hand, mutual funds are bought or sold at the end of the day at the NAV (Net Asset Value). It's like placing an order at a restaurant and getting your meal after they've cooked it.

• Cost Efficiency:

ETFs often have lower expense ratios compared to mutual funds. Think of it like buying a product directly from the manufacturer – fewer middlemen, lower costs. Mutual funds may have higher expense ratios because they involve more management and administrative fees. It's like paying a bit more at a convenience store for the convenience.

• Minimum Investment:

ETFs allow you to start with a single share. It's like buying one chocolate bar instead of a whole box. Mutual funds might have a minimum investment requirement, like buying a certain number of units. It's like having to buy a minimum quantity at a wholesale store.

• Intraday Trading:

ETFs can be traded throughout the day, and you can react quickly to market changes. It's like changing your plans on the go. Mutual funds are settled at the end of the day, so you can't react to intraday market movements. It's like making plans and sticking to them no matter what.

• Transparency:

ETFs disclose their holdings daily, so you always know what you own. It's like checking the ingredients on a food label. Mutual funds disclose their holdings less frequently, usually monthly. It's like knowing the recipe but not all the exact ingredients.

• Tax Efficiency:

ETFs are generally more tax-efficient because of the "in-kind" creation and redemption process. It's like finding a tax loophole that works in your favour. Mutual funds might distribute capital gains to investors, which could lead to tax implications. It's like unexpectedly getting a tax bill after a nice dinner.

Wrapping Up

In simple terms, index funds like Nifty 50, Nifty Next 50, and Nifty Midcap 150 are more efficient and easy to invest than mutual funds. Why? Well, it boils down to low fees, the market getting smarter, and fund rules limiting how much they can stray from the popular indices.

Choosing these outperforming funds and managers is like finding a needle in a haystack. Even if you find a star manager, their success often doesn't last. The fund shining bright today could be the one in the shadows tomorrow.

For big companies (large-caps), it's a total no-brainer to go for index funds. There's plenty of proof that the same logic applies to mid-sized companies. However, things get dicey when it comes to small companies (small-caps). They're riskier, and just holding onto them might not be the smartest move. It's a game that requires active management, both in terms of the fund and timing.

So, in the Indian market, going for index funds in the big and mid-size sectors is a smart move. But with small companies, be cautious – it's a different ball game.