Exchange Traded Funds (ETFs) have suddenly become very popular, receiving a lot of media attention and interest from investors – yet most of us don’t really know what exactly are ETFs & how they function.
What is Exchange Traded Funds ?
Like a mutual fund, an ETF is also a basket of securities – but unlike mutual funds (and similar to stocks), ETFs trade daily on an exchange under a ticker with live intraday prices.
Rather than subscribing/redeeming units from the mutual fund house only once a day, investors can buy/sell their ETF units via their brokerage account anytime during market trading hours.
Exchange Traded Funds combine the diversification benefits of mutual funds with the liquidity and trading advantages of single stocks.
Most ETFs in the world today are passive – they either track an existing index like the Nifty-50, or follow a systematic rules-based approach to selecting stocks that is predefined and transparent.
There is no discretionary element in such ETFs, where a particular fund manager or investment committee will take active judgment calls based on their current and future market views.
However, ETFs can be active as well – in such ETFs, the fund manager has the discretionary power to break away from the systematic rules of their chosen benchmark and own a basket of securities that are different from the benchmark index.
The Global Popularity of ETFs
Since their launch, ETFs have become extremely popular with institutional and retail investors across the globe. The global financial crisis of 2008 was an inflection point for the ETF industry, as the low-cost & other advantages of ETFs came to the forefront of investor focus during this stressful time
- Assets invested in the Global ETF industry reached $5.18 trillion in February 2019, the highest on record
- Global AuM in ETFs has grown at 20.1% CAGR over the past 10 years
- 61 consecutive months of net inflows into ETFs listed globally
- Not surprisingly, US is the largest market for ETFs in terms of asset size & offerings
Exchange Traded Funds in India
The first ETF in India was created in 2001, when Benchmark Mutual Fund launched the Nifty ETF Fund with a defined objective to track the performance of the Nifty-50 index. Since then, the ETF industry in India has witnessed a slow but steady growth.
There was a period in between when ETFs became associated with a convenient way to invest in gold, especially in the mid-late 2000s. However, the ETF landscape today has evolved to include different segments of the equities market, gold, fixed income, and even the recently launched real-estate focused REITs.
Advantages & Disadvantages of ETF
As mentioned, the ETF instrument was created in the 1990s whereas the mutual fund structure was created in the early 1920s. As such, ETFs build on the benefits of mutual funds by operating a more efficient structure that has many advantages for the retail & institutional investors, as well as the AMCs.The Key Advantages of ETFs
| Exchange Traded Funds (ETFs) | Mutual Funds | |
|---|---|---|
| Liquidity | ETFs offer instant liquidity & can be traded anytime during market hours | Subscription & redemption process can take 1-3 days |
| Diversification | They are a diversified portfolio/basket of stocks | They are a diversified portfolio/basket of stocks |
| Expenses | Expense ratio is usually lower than comparable MFs | Expense ratio is usually higher than comparable ETFs |
| Exit Loads | No exit load or penalties | Many funds charge 1% in case the investment is redeemed within 1 year |
| Cash Holdings | ETFs hold no cash – as such, all money is put to work | MFs can hold cash for the investor – often this drags down performance |
| Transparency | Very transparent; holdings published on a daily basis | Less transparency into holdings, which is published once a month |
| Advanced Trades | Expert investors can use ETFs to place limit orders & even trade in derivatives based on ETFs | Such expert trades can’t be done with mutual funds |
Disadvantages of ETF
- ETFs that track an index suffer from something called tracking error, which is the difference between the index return and the fund return – note though, this is also applicable to any passive mutual fund which is tracking an index
- In rare times of poor liquidity, the bid/ask spread (i.e. the buying/selling costs) can be high leading to higher costs
- In India, placing SIPs into ETFs aren’t as convenient as they are in mutual funds
- Lastly, there aren’t many varieties of ETFs in India yet – current offerings are limited to large & midcap index trackers, gold, and debt. However, this will change as its popularity & penetration increases – today, the developed markets have all kinds of niche ETFs, but they started off in a similar vanilla fashion.
