Exchange Traded Funds (ETFs) have significantly gained popularity among individual and institutional investors over the past few decades. An ETF is an investment fund traded on stock exchanges, much like equity shares. ETFs hold a collection of assets such as stocks, commodities, or bonds and are designed to track the performance of a specific index. This article delves into how ETFs work and the various benefits they provide to investors.
How Exchange Traded Funds Work
Structure and Composition
Exchange traded funds are structured as open-end mutual funds or unit investment trusts. The ETF tracks a specific index, sector, commodity, or other assets, meaning it holds the underlying assets in the same proportion as the index it is tracking. For instance, an ETF following the Nifty 50 index will invest in the 50 constituent companies of the Nifty 50 in the same proportions as the index.
Creation and Redemption
The creation and redemption mechanism is a unique feature of ETFs. Authorized participants (APs) are entities such as market makers and large financial institutions responsible for creating or redeeming ETF shares. When APs want to create new ETF shares, they buy shares of the underlying assets and exchange them with the ETF provider for ETF shares. Conversely, to redeem ETF shares, APs return the ETF shares to the provider in exchange for the underlying assets.
This mechanism ensures that an ETF’s market price remains in line with its Net Asset Value (NAV). When there’s a price discrepancy, arbitrage opportunities arise, encouraging APs to step in, thereby realigning the ETF’s market price with its NAV.
Key Benefits of Exchange Traded Funds
Diversification
One of the primary advantages of investing in ETFs is diversification. An ETF usually comprises a broad mix of securities, allowing investors to spread their risk across various assets. For example, investing in an ETF that tracks the Nifty 50 allows investors to benefit from the performance of 50 different leading companies in the Indian market rather than putting all their money into a single stock.
Cost Efficiency
ETFs are generally more cost-efficient compared to mutual funds. The expense ratios of ETFs are relatively low because they are passively managed, tracking an index without frequent buying and selling of stocks. For example, if an ETF tracking the Nifty 50 charges an expense ratio of 0.5%, an investor with ₹1,00,000 invested would pay ₹500 per year in management fees. In contrast, actively managed mutual funds typically have higher expense ratios due to higher research and trading costs.
Liquidity and Flexibility
ETFs offer high liquidity as they are traded on stock exchanges throughout the trading day at market prices. This allows investors to buy and sell ETF shares much like equity shares. The flexibility in trading enables investors to execute various strategies, such as entering or exiting positions at intraday prices, which is not possible with mutual funds that trade only at their NAV, calculated at the end of each trading day.
Transparency
Most ETFs disclose their holdings daily, providing investors with transparency regarding the assets in the fund. This is a significant advantage over mutual funds, which typically disclose their holdings quarterly. Knowing what assets are in the ETF helps investors make informed decisions and understand the risk profile of their investments.
Tax Efficiency
ETFs tend to be more tax-efficient compared to mutual funds. In India, equity ETFs held for more than one year qualify for long-term capital gains tax, which is currently taxed at 10% on gains exceeding ₹1,00,000. Short-term gains from ETFs are taxed at 15%. The “in-kind” creation and redemption process minimizes the capital gains distributions that investors must pay, making ETFs a tax-efficient investment choice.
Calculations and Performance Metrics
Understanding the performance of an ETF involves several metrics and calculations. Here are key performance indicators:
1. ETF Price vs. NAV: ETFs can trade at a premium or discount to their NAV. If the market price is above the NAV, the ETF is trading at a premium; if below, it’s at a discount. For example, if an ETF’s NAV is ₹100, but it is trading at ₹102, it has a 2% premium.
2. Tracking Error: This measures how closely the ETF follows the index it tracks. A lower tracking error indicates better performance. If an ETF tracks the Nifty 50 index, which returns 10%, but the ETF returns 9.8%, the tracking error is 0.2%.
3. Expense Ratio: This is the annual fee ETFs charge investors, expressed as a percentage of assets under management. If an ETF with an asset size of ₹100 crore (₹1000 million) charges a 0.5% expense ratio, it costs ₹50 lakh (₹5 million) annually.
Real-Life Scenarios
Portfolio Diversification
Consider an investor with ₹10,00,000 looking for diversification between large-cap and small-cap stocks. Instead of picking individual stocks, the investor might buy units of ETFS tracking the Nifty 50 (large-cap) and Nifty Smallcap 250 (small-cap). By purchasing:
– ₹5,00,000 in Nifty 50 ETF
– ₹5,00,000 in Nifty Smallcap 250 ETF
The investor gains exposure to 300 different companies across both market caps, significantly reducing the risk linked to individual stock volatility.
Strategic Allocation
Suppose an investor wants to capitalize on the booming IT sector in India. They can purchase an ETF comprised of equity shares in IT companies rather than selecting individual stocks. If the Nifty IT ETF has an expense ratio of 0.6% and returns 15% annually, an investment of ₹1,00,000 would yield around ₹1,48,500 before considering expense ratios over three years, assuming consistent returns and reinvestment.
Conclusion
ETFs offer numerous benefits for investors, including diversification, cost efficiency, liquidity, transparency, and tax efficiency. They provide an effective way of investing in a broad range of assets with relative ease. However, like any investment, ETFs come with risks linked to market volatility and index performance.
Disclaimer
Investors should carefully evaluate all the pros and cons of trading in the Indian stock market and consider their risk tolerance and investment goals. The information provided in this article is for informational purposes only and should not be considered financial advice. Consult with a licensed financial advisor before making any investment decisions.