All about Exchange Traded Funds (ETFs)

Financial planning using mutual funds is one of the most easiest roads to riches. Especially if you were to use the systematic investment planning route. While you could choose any type of mutual fund to invest in, one of the best options available to investors is Exchange Traded Funds (ETFs).

I keep screaming from this blog that personal finance is simple, and you can achieve financial freedom by avoiding products like non-term insurance plans; futures and options and even stocks ! One of the products to fall back for a simple personal financial life is exchange traded funds.

Let’s us take a look at what they are.

What are Exchange Traded Funds or ETFs?

These are index mutual funds that are traded on the stock exchange. In that sense, they are like a stock and a mutual fund both.

An index fund is an equity fund that tracks a market index say BSE Sensex or Nifty. The index fund holds the same stocks in the same proportion as the index does. So ETFs are nothing but index funds which can be traded on the stock exchange.

They are like mutual funds as they constitute a basket of underlying entities much like conventional mutual funds. Conventional mutual funds invest in stocks and bonds among other assets (say gold). In a similar way, ETFs are like mutual funds and can have any type of underlying asset.

They are like stocks as you can buy and sell them during trading hours as if you were trading a stock.

ETFs track an index. While doing so, they can be actively managed or passively managed.

When they are actively managed, they try and outperform the benchmark index which they track. When they are passively managed, the ETF constitutes its underlying asset (say stocks) in the same proportion/weight as the benchmark index.

They can be both open ended and close ended. So after the new fund offer, open ended ETFs can issue out new units.

In conventional mutual funds, investors directly buy units by paying cash to the fund house.  It is the fund house which buys and sells stocks to form the mutual fund portfolio. In ETFs, when the fund is initially setup, the stocks are exchanged for units of the mutual fund. These units are then sold to investors through brokers. That is why investors have to pay brokerages when they buy ETFs but no loads.

What is the difference between ETFs and ordinary mutual funds?

Such funds are not really same as conventional mutual funds. There are significant differences between the two.

1. ETFs are bought and sold real time on the stock exchange. However, mutual funds can be bought and sold at their NAVs. NAVs are declared only once during the end of the day so as an investor, you can buy and sell it only at this NAV as opposed to ETFs which you can literally trade like a stock during normal trading hours.

2. In ETFs, one needs to buy and sell units on the stock exchange. In conventional mutual funds, investors buy and sell directly from the fund house.

3.  ETFs have lower expense than mutual funds. Historically an average expense ratio of 0.5% is a good figure to go with but it could go to a maximum of 1% as well. Conventional mutual funds can have expense ratios of up to 2.5%! Also note that ETFs do not charge any exit loads when you sell while conventional mutual funds do.

4. The portfolio of ETFs remains static as they mimic index funds. The portfolio of conventional mutual funds is changing. Because of this, one generally knows the portfolio constituents of such funds always while that of mutual funds only on disclosures.

Advantages and disadvantages of ETFs

Some of the advantages are :

1. Their ease of use is immense. All you need to do to trade in ETFs is have a demat account and a trading account with a broker. Most of the India investors who dab their hands in stocks, will have both of these so you do not have to create any more accounts.

2. Smaller investments in ETFs is possible. The NAV of a ETF is a fraction of the value of the index it tracks. So, the NAV of an ETF that tracks the Nifty which is at say 4500 will be Rs 450. Now this makes it very easy for investors to buy into equity with a small amount of money. If you were to mimic the ETF yourself by directly buying stocks, you will need to purchase all the stocks in the index yourself – that could possibly make it very expensive for you.

3. They are passively managed, have low distributions costs and expense ratios.

The disadvantage is that :

1. You have to place a SIP each month and when you do that, you have to pay brokerage each time you buy and each time you sell. Index funds can prove to be better than ETFs for SIPs.

2. ETFs are not very well known to investors as are stocks and diversified equity mutual funds. So they are challenged on the liquidity front.

Who should invest in Exchange Traded Funds ?

ETFs offer advantages in the form of lower costs and convenience of investing and their returns blossom over long periods of time. So they are a great vehicle for long term investors.

The intra-day trading facility offered by ETFs often attracts traders but holds little relevance for long-term investors.

If an investor is looking for a long-term and passive investment approach to equities, ETF offers an alternative to index-based funds.

So if you have a long term goal or even a medium term goal in your porfolio, you can look at ETFs.

These funds have not become popular as  their concept is not well known and their returns are in line with the index they track. Investors like the adrenaline rush of returns that stocks and equity diversified mutual funds offer. That is rather unfortunate as ETFs offer one of the best ways to invest in equity and other asset classes.