Exchange-traded funds (ETFs) have been gaining investor interest. ETFs are essentially index funds that are listed and traded on exchanges like stocks. They enable investors to get a broad exposure to the stock markets in different countries, and specific sectors, with relative ease, on a real-time basis. This also comes at a lower cost than many other forms of investments.
An ETF represents a basket of stocks that reflects the composition of an index, like metals index, BSE Sensex or the banking index. An ETF's trading value is based on the net asset value (NAV) of the underlying stocks that it represents. It is similar to a mutual fund that one can buy and sell in real time at a price that changes during the trading session. In India, the two popular ETFs are index ETFs and commodity ETFs. Most ETFs in India are index funds that hold securities. They try to mirror the performance of a stock market index.
As the ETFs are listed on the exchanges, distribution and other operational expenses are significantly lower as compared to investing in a commodity. ETFs can be easily bought and sold like stocks during trading hours using your demat account with no additional paperwork. They have a lower expense ratio and the minimum investment is one unit.
To buy and sell ETFs you need a trading account. ETFs are bought through a broker. So, every time you trade you also end up paying brokerage for your transaction. However, ETFs allow investors to take the benefits of intra-day movements in the markets, which is not possible with open-ended funds.
Unlike regular open-ended mutual funds, ETFs can be bought and sold throughout the trading day like any stock. These funds rely on an arbitrage mechanism to keep the prices at which they trade roughly in line with the NAVs of their underlying portfolios. In order to let the mechanism work, the potential arbitragers need to have full, timely knowledge of a fund's holdings.
ETF units are continuously created and redeemed based on investor demand. Investors may use ETFs to invest, trade or arbitrage. The price of the ETF tracks the value of the underlying index. This provides an opportunity to investors to compare the value of an underlying index with the price of the ETF units prevailing on the exchange. If the value of the underlying index is higher than the price of the ETF, the investors may redeem the units. In case the price of the underlying securities is lower than the ETF, investors may create ETF units by depositing the lower-priced securities. This arbitrage mechanism eliminates the problems associated with close-ended mutual funds - the premium or discount to the NAV.
The number of outstanding ETF units is not limited, as with traditional mutual funds. It may increase if investors deposit shares to create ETF units, or it may reduce on a day if some ETF holders redeem their ETF units for the underlying shares. These transactions are conducted by sending creation or redemption instructions to the fund.
ETFs provide investors with exposure to broad segments of the equity markets. They enable investors to build customised investment portfolios in line with their risk-taking ability and time horizon. Moreover, as ETFs are liquid, they provide investors an avenue to park their funds while taking investment decisions. Also, ETFs can be used as hedging vehicles because they can be bought and sold short. The smaller denominations in which ETFs trade relative to most derivative contracts provides a more accurate risk exposure match, particularly for small investment portfolios.
