Advantages & Applications of Exchange Traded Funds(ETFs):
Exchange Traded Funds(ETFs) are listed and traded on exchange much like stocks. ETFs tracks an index, a commodity, a bond or a basket of securities. ETFs are traded closer to its NAV throughout the day, which is calculated on a real time basis. Here is a complete guide for beginners to invest in ETFs.
ETFs were first introduced in the year 1993 in the USA. However, the first ETF in India was launched in Jan 2002 by Benchmark Mutual Fund; “Nifty BeES(Nifty Benchmark Exchange Traded Scheme) based on Nifty50. It can be purchased and sold like any other stocks on NSE.
Why should you invest in ETFs?
Exchange Traded Funds(ETFs) offer a wider scope of investment options and broad diversification to the investors as it gives the exposure to various indexes across the globe such as S&P 500, Russell 1000, Standard & Poor’s 100, NASDAQ-100, Dow Jones, Nifty 50, etc.
It gives exposure to the indexes based on:
• Market sectors like infra, agriculture, power, health care, technology, etc.
• Market cap: large-cap, mid-cap, small-cap.
• Asset classes like commodities, real estate, currency, fixed-income, etc.
Also, the expense ratio of ETFs is low as compared to other investment options that are actively managed, the smaller unit size gives you an option for Systematic Investment.
ETFs vs Mutual Funds
ETFs offers various advantages over traditional mutual funds as they are traded throughout the day and the NAV in ETFs is closer to the actual NAV of the scheme thereby reducing the price differential risk between the time of investment and the time of the trade.
Let me take you through some of the significant differences between ETFs and Mutual Funds:
ETF vs Stocks
The primary objective behind ETFs is passive investing.
ETFs generate the returns closer to the underlying assets that are being tracked. Passively managed ETFs invest in the same stocks and in the same proportion as its index while trying to replicate the performance of its benchmark index. ETFs are a good mode of investment for the investors who believe in buy and hold strategy and does not assess the market risk on its own. The objective of the fund is quite simple; be closer to its index.
Advantages attached to the ETFs are broad diversification and lower expenses i.e. cost of researching industries, sectors, stocks, etc. gets eliminated. Another good thing about ETFs are; they don’t look at the past performance nor any future forecast of the underlying asset.
On the other hand, stocks are actively managed, and it requires fund managers to track continuously the performance which results in higher cost. The rationale behind active management is to outperform the markets. However, in most of the cases, it is not achieved.
Various ETF schemes listed on NSE are as follows:
• Equity- Equity ETFs are passive investment instruments based on indices and invest in securities in the same proportion as the benchmark index. Some of the Equity ETFs listed on NSE are:
• Gold- Gold in India is considered to be an asset of pride and honour. However, holding gold in physical form may come along with several drawbacks such as security concern, quality, resale value, taxation, etc. Hence, it would be apt to go for a Gold Exchange Traded Funds than holding gold in the physical form. Gold ETFs are based on gold prices and invest in gold bullion. Some of the Gold ETFs listed on NSE are:
• World Indices- Global equity Exchange Traded Funds gives the exposure of international market to the investors. Some of the Global Index ETFs listed on NSE are:
• Debt- It gives the exposure to fixed income securities. Some of the Debt ETFs listed on NSE are:
How to invest in ETFs
You can invest in ETFs by opening a Demat account and a share trading account with a broker. Once the account is open, you can call the broker and place your order or you can do the transactions through the online platform of your trading account.
Advantages of ETFs
Some of the advantages are as follows:
• ETFs transactions can be easily done on the exchanges through terminals across the country.
• It gives the investors, the advantage of the prevailing price on a real time basis which is closer to the actual NAV of the scheme throughout the day.
• It offers investors, the flexibility of purchase and sale throughout the day.
• Due to its listing on an exchange, cost of distribution is lower. Also, the structure of ETFs is such that the collection, disbursement and other processing charges are low, thereby resulting in lower charges for the investors.
• It allows the authorised participants and large institutions to create new units and redeem outstanding units directly with the fund.
• Due to its flexible nature, ETFs can be used to gain exposure to the equity markets. ETFs can also be used as an arbitrage between the cash and the futures market.
• Tracking error is usually low as compared to index fund due to lower expenses and the “in-kind creation/ redemption” process.
ETFs are designed in a way to track an index i.e. they try to deliver returns closer to the index they follow. However, sometimes the difference arises between the two due to factors such as total expense ratio, trading cost etc.
Tracking error is used to measure the variability in the funds performance compared to its underlying index. It is defined as the standard deviation of daily return differences between the ETFs performance and its underlying index. In simple words, we can say that Tracking error measures the volatility in the difference of the ETFs performance and its underlying index.
The lower the tracking error, the better is the ETF; as its return will be closer to that of its underlying index.
Applications of ETFs
ETFs can be used for the below purposes:
• Efficient Trading: ETFs provides easy access to market through an index. Depending on the index, investors can expose themselves to other countries exchanges/markets. They can also choose to invest in various sectors.
• Cash Utilisation: Investors having idle cash are always in search of a product that is linked to market like an index. They can use ETFs as a temporary investment tool till their search ends. This can help the investors save the potential opportunity costs.
• Cash Flow Management: ETFs gives liquidity and can represent markets at any time because of which the investment managers can use them.
• Filling Space: As ETFs gives exposure to various sectors, one can use it to increase/decrease exposure to multiple sectors.
• Safeguarding against Risk: ETFs can be used as an instrument to safeguard against the market risk as they can be borrowed and sold instantly. As ETFs are traded in smaller denominations, it provides veracious exposure to market risk, especially in the case of small portfolios.
• Arbitrage Option: Investors can use ETFs as an arbitrage to trade between cash and futures market.
Exchange Traded Funds have been designed for the passive investors and work in line to achieve the returns closer to its underlying index. It reduces the burden of continuous tracking and higher cost for the investors. It also gives the investors broad diversification and exposure to various indexes.