What Is an Exchange-Traded Fund (ETF)?
Exchange-traded funds, commonly known as ETFs, are a collection of
various securities such as bonds, shares, money market instruments,
etc., that often track an underlying asset. Simply put, ETFs are a
mashup of different investment avenues. They offer the best
attributes of
two popular financial assets – mutual funds and stocks.
ETF funds are somewhat like mutual funds in terms of their
structure,
regulation, and management. Additionally, just like mutual funds,
they
are a pooled investment vehicle that offers diversified investment
into
various asset classes like stocks, commodities, bonds, currencies,
options, or a blend of these. Moreover, they can even be traded like
stocks on the stock exchanges.
To understand this better, let’s comprehend the difference between
open-ended and close-ended mutual funds.
Open-Ended vs. Close-Ended Mutual Funds
Traditional open-ended mutual funds can be bought or sold at any
time
from the fund company itself. However, close-ended mutual funds
offer a
fixed number of shares during the initial public offering (IPO),
after which
shares can be only bought from or sold to other shareholders in the
open market.
One key difference: with open-ended funds, your counterparty is
always
the fund company itself. They will trade the securities at their Net
Asset
Value (NAV) at the end of the day. If you buy them after the markets
have opened, you get the fund’s closing price for that day. If you
buy
them after the markets have closed, you are offered the fund’s
closing
price for the next business day.
On the other hand, with close-ended funds and exchange-traded funds,
your counterparty isn’t usually the fund company itself. They are
other
shareholders who trade all day long, either directly or over stock
exchanges. Hence, you can trade these funds at a price suitable to
you.
ETFs and Close-Ended Funds
ETFs and close-ended funds are like close cousins because both
financial products can be bought or sold over the stock exchanges.
However, unlike close-ended funds, an exchange-traded fund is not
actively managed. Instead, the securities in an ETF fund simply form
a
basket of investments intended to replicate an index as closely as
possible. You can think of ETFs as close-ended index funds that are
traded over exchanges.
Types of Exchange Traded Funds (ETFs)
There are several
ETFs available to suit the demands of almost all
investors.
Following are some types of ETFs available to an individual:
- 1. Bond ETFs These are typical ETFs designed to provide exposure to different types of bonds. Investing in bonds is a good way to mitigate the ups and downs of investing and diversifying a portfolio.
- 2. Currency ETFs: These securities allow an investor to participate in currency market transactions without purchasing a specific currency. The motive of such investments is to track and benefit from the price fluctuations of a particular currency or a basket of currencies.
- 3. Inverse ETFs: Such funds are designed to return the opposite of what is offered by the underlying market index. With these funds, share prices move in the opposite direction of the inverse ETFs’ share.
- 4. Liquid ETFs: These funds try to minimize price risks and enhance returns by investing in a basket of short-term government securities, such as money and money market instruments with short maturities, while simultaneously attempting to maintain liquidity.
- 5. Gold ETFs: Such securities offer investors the path to hold claims in the bullion market without making it necessary to purchase physical gold. You could also purchase ETFs that focus on precious metals in general.
- 6. Index ETFs: Index funds track the performance of their underlying index. They are further subdivided into replication and representative ETFs. Index funds that invest entirely in the securities underlying the index are called replication ETFs. On the contrary, representative ETFs are those that invest a majority of their fund corpus in representative samples and the remaining in other securities such as futures, options, etc.
- 7. Commodity ETFs: As their name indicates, commodity ETFs invest in commodities including crude oil or metals. Commodity ETFS provide several benefits. First, they diversify a portfolio, making it easier to hedge downturns. For example, commodity ETFs can provide a cushion during a slump in the stock market. Second, holding shares in a commodity ETF is cheaper than physical possession of the commodity. This is because the former does not involve insurance and storage costs.
Advantages of Exchange Traded Funds (ETFs)
- 1. Liquidity: ETFs can be sold throughout the day over stock exchanges, though some funds are more frequently traded than others. The more regularly a fund is traded, the easier it is to find a willing seller or buyer.
- 2. Lower cost: ETFs have much lower expense ratios than traditional mutual funds. This is because ETF shareholders are not mandated to pay for the team of managers, analysts, and brokers to trade funds on their behalf or manage the fund’s inflows and outflows.
- 3. Transparency: Unlike mutual funds that are only instructed to disclose their holdings quarterly, ETFs disclose the fund’s holdings and its NAV daily for open- ended schemes and close-ended schemes.
- 4. Diversification: ETFs allow investors to diversify their portfolio across horizontals such as industries, sectors, styles, or countries. ETFs are also traded on virtually every major asset class, currency, and commodity in the world.
Uses of ETFs
ETFs can prove quite useful to those investors who demand focused
exposure to a specific industry, asset class, region, or currency at
a
reasonable cost. Such investors do not have to worry about
researching
specific industries. What’s more, thanks to their low operational
expenses, they are also suitable as long-term holdings for ‘buy
& hold’
investors.
Additionally, they are useful to those who are looking forward to
the
asset allocation approach to investing. It is possible to find an
exchange-
traded fund that focuses on asset classes and has a very low
correlation
coefficient with the rest of your portfolio. In other words, if your
portfolio
‘zigs,’ the ETFs you are seeking tends to ‘zag.’ Ideally, this
results in less
volatility for your portfolio.
ETFs are one of the fastest-growing financial products in history.
Now
that you are armed with the basics of exchange-traded funds in
India,
you can make your mind and decide whether they make sense for your
portfolio.
Examples of Popular ETFs
Below are examples of popular ETFs on the market today. Some ETFs
track an index of stocks, thus creating a broad portfolio, while
others
target specific industries.
- - The SPDR S&P 500 (SPY): The Spider is the oldest surviving and most widely known ETF that tracks the S&P 500 Index.
- - The iShares Russell 2000(IWM) : tracks the Russell 2000 small- cap index.
- - The Invesco QQQ (“cubes”) : tracks the Nasdaq 100 Index, which typically contains technology stocks.
- - The SPDR Dow Jones Industrial Average (DIA) (“diamonds”) : represents the 30 stocks of the Dow Jones Industrial Average.
- - Sector ETFs track individual industries and sectors such as oil (OIH), energy (XLE), financial services (XLF), real estate investment trusts (IYR), and biotechnology (BBH).
- - Commodity ETFs represent commodity markets, including gold (GLD), silver (SLV), crude oil (USO), and natural gas (UNG).
- - Country ETFs track the primary stock indexes in foreign countries, but they are traded in the United States and denominated in U.S. dollars. Examples include China (MCHI), Brazil (EWZ), Japan (EWJ), and Israel (EIS). Others track a wide breadth of foreign markets, such as ones that track emerging market economies (EEM) and developed market economies (EFA).
ETFs vs. Mutual Funds vs. Stocks
Comparing features
for ETFs, mutual funds, and stocks can be a
challenge in a world of ever-changing broker fees and policies. Most
stocks, ETFs, and mutual funds can be bought and sold without a
commission. Funds and ETFs differ from stocks because of the
management fees that most of them carry, though they have been
trending lower for many years. In general, ETFs tend to have lower
average fees than mutual funds. Here is a comparison of other
similarities and differences.
| Exchange-Traded Funds | Mutual Funds | Stocks |
|---|---|---|
| Exchange-traded funds (ETFs) are a type of index funds that track a basket of securities. | Mutual funds are pooled investments into bonds, securities, and other instruments that provide returns. | Stocks are securities that provide returns based on performance. |
| ETF prices can trade at a premium or at a loss to the net asset value (NAV) of the fund. | Mutual fund prices trade at the net asset value of the overall fund. | Stock returns are based on their actual performance in the markets. |
| ETFs are traded in the markets during regular hours just like stocks are. | Mutual funds can be redeemed only at the end of a trading day. | Stocks are traded during regular market hours. |
| Some ETFs can be purchased commission-free and are cheaper than mutual funds because they do not charge marketing fees. | Some mutual funds do not charge load fees, but most are more expensive than ETFs because they charge administrative and marketing fees. | Stocks can be purchased commission-free on some platforms and generally do not have charges associated with them after purchase. |
| ETFs do not involve actual ownership of securities. | Mutual funds own the securities in their basket. | Stocks involve physical ownership of the security. |
| ETFs diversify risk by tracking different companies in a sector or industry in a single fund. | Mutual funds diversify risk by creating a portfolio that spans multiple asset classes and security instruments. | Risk is concentrated in a stock’s performance. |
| ETF trading occurs in-kind, meaning they cannot be redeemed for cash. | Mutual fund shares can be redeemed for money at the fund’s net asset value for that day. | Stocks are bought and sold using cash. |
| Because ETF share exchanges are treated as in-kind distributions, ETFs are the most tax-efficient among all three types of financial instruments. | Mutual funds offer tax benefits when they return capital or include certain types of tax- exempt bonds in their portfolio. | Stocks are taxed at either ordinary income tax rates or capital gains rates. |
The Bottom Line
Exchange-traded funds, or ETFs, represent a cost-effective way
to gain
exposure to a broad basket of securities with a limited budget.
Instead
of buying individual stocks, the investor can simply buy shares of a
fund
that targets a representative cross-section of the wider market.
However, there are some additional expenses to keep in mind when
investing in an ETF.
The six broad categories of Exchange-Traded Funds in India are Index
ETFs, Gold ETFs, Sector ETFs, Bond ETFs, Currency ETFs, and Global
Index
ETFs. Most ETFs are registered with the Securities and Exchange
Board of India (SEBI). https://www.nseindia.com/market-data/exchange-traded-funds-etf