Exchange Traded Funds (ETFs)

What are ETFs?

• Exchange Traded Funds (ETFs) are mutual funds that trade like stocks. ETFs track an underlying index e.g. Nifty 50, Sensex
• To track the underlying index as closely as possible, equity ETFs aim to own the same securities in the same proportion (weights) as the underlying index
• ETFs are traded during market hours, allowing investors to make investments and execute their trading strategies in real time
• Investors require a demat account to invest in ETFs

How do ETFs work?

The ETF Fund Manager aims to own the same securities in the same proportion (weights) as the underlying index. The Fund Manager will rebalance the portfolio ie. buy / sell securities as they move in / out of the index to ensure the ETF is tracking the index as closely as possible.

Investors who are transacting in amounts less than Rs. 25 crore per transaction can transact in ETFs directly on stock exchanges. In order to provide liquidity for ETFs, AMCs appoint Market Makers (MMs). MMs are market participants stand ready to buy and sell units from investors i.e. providing 2way quotes for ETFs. They allow investors to build or exit their ETF positions easily and also help keep the ETF price in line with its fair value i.e. iNAV (Indicative Net Asset Value). This is because Market Makers can subscribe / redeem units directly with the AMC. By quickly adjusting supply of units to match demand, they keep the market price of the ETF close to iNAV.

Factors to be considered while investing in ETFs

First, investors need to assess if an ETF is suitable for them - will it help achieve their financial goals and does it match their risk tolerance? For example, if an investor is saving for retirement and has a long investment horizon, they can invest in equity ETFs. However, they need to have enough risk tolerance to handle market volatility and fluctuations along the way. On the other hand, if an investor’s financial goal is only a few months or years ahead, then they can consider investing in debt ETFs, which offer more stability but lower returns on average.

The underlying index the ETF tracks is mentioned in the ETF scheme name itself. Investors should first identify the category of ETF that will help them achieve their financial goals. For example, do they want to buy an equity or debt ETF? Within equity, do they want exposure to a broad market index like the Nifty 50, Sensex etc. or to specific Sectors, Themes, Smart Beta investing etc.?

Once they have identified the category that is suitable for them, they should keep the following in mind to choose a particular ETF:

a) Total Expense Ratio (TER) – This is the cost of running and managing a mutual fund scheme.

All else equal, a lower TER is preferable as this results in lower costs for the investor

b) Tracking Error (TE) and Tracking Difference (TD) – These measure how well the ETF is tracking its benchmark.

Tracking Error (TE) is the annualized standard deviation of the difference in daily returns between the underlying index and the NAV of the ETF, based on past one year rolling data

Tracking Difference (TD) is the annualized difference of daily returns between the index and the NAV of the ETF. TD over a given period is = ETF NAV CAGR (Compound Annual Growth Rate) – Benchmark CAGR

A low TE and TD are preferable, as it shows the scheme is tracking its benchmark closely.

c) Liquidity and Impact Cost– Investors should choose ETFs which have high liquidity, so that even large transactions can be executed with minimal impact on the market price. Investors can monitor daily traded value of ETFs and give preference to those ETFs which have higher average daily traded value.

In addition, investors can compare the impact cost of various ETFs and give preference to ETFs which have lower impact cost. Impact cost represents the cost of executing a transaction in an ETF, for a specific predefined order size, at any given point of time. Hence lower impact cost is desirable.

How to Invest in ETFs?

Investors who are transacting in amounts less than Rs. 25 crore per transaction can transact in ETFs directly on stock exchanges. Investors should enter the ETF’s exchange symbol on their trading platform and then transact accordingly – it is exactly the same process as investing in stocks through their trading platform. ETF symbols can be obtained from the Mutual Fund’s factsheet, website, SID/KIM etc.

Should I invest in an ETF or Index Fund? It is important to note that ETFs and Index Funds both have the same objective – to mirror the underlying index as closely as possible. Thus, the decision for an investor to choose an ETF or Index Fund depends more on their personal objectives and circumstances. Investors who have a demat account and desire the flexibility to buy / sell during market hours can consider ETFs. Other investors who do not wish to invest via demat account or wish to avail of the convenience of investing with the AMC can consider purchasing Index Funds. A detailed comparison of ETFs and Index Funds is given in the table below.

	ETFs	Index Funds
Objective	Both ETFs and Index Funds have the same objective– to track / mirror the underlying index as closely as possible
Demat account	Required	Not required
Mode of transacting	Investors can buy / sell ETFs on the exchange in real time during market hours Large investors can transact directly with the AMC in amounts greater than Rs. 25cr.	Investors subscription / redemption processed at end of day NAV
SIP	Most brokerages allow ‘Stock SIPs’ which can be used for ETFs as well	SIPs and other smart investment solutions available with the AMC
Minimum investment	1 unit of the ETF	Investible with minimum amount of Rs. 100 and above.
Expense structure	Ongoing: Fund TER (generally lower than Index Funds) While transacting: Transaction costs + impact costs	Ongoing: Fund TER

 

To learn more about Exchange Traded Funds (ETFs) visit: https://www.amfiindia.com/investorcorner/knowledge-center/etf.html