Exchange traded fund or ETFs are passive mutual fund schemes tracking market indices. ETFs do not aim to beat the market segment(s) they are tracking; they simply aim to give market returns. Exchange traded funds are very popular globally and are increasingly becoming popular in India as well.
As per AMFI data, ETF is the largest mutual fund schemes category in India now.
Benefits of ETFs
The two biggest benefits of exchange traded funds are low cost and no unsystematic risk. Since ETFs simply aim to track the market, they invest in the basket of securities that constitute the market. The weight of an index constituent in ETF portfolio is same as its weight in the index.
Since ETFs do not need active fund management, their costs (TER) are lower than actively managed mutual funds. Since ETFs track the index, it is unbiased by human (fund manager) judgement. For the same reason, there is no unsystematic risk in ETFs.
How to invest in ETFs?
You need to have Demat and trading accounts to invest in an ETF. During the NFO period, you can subscribe for ETF units directly with the Asset Management Company (AMC). After the NFO period, you can buy / sell ETF units in stock exchanges like shares of public companies, unless you are transacting in lot sizes (creation units) as specified by the AMC. The creation unit size of an ETF is usually quite large; larger the average investment size of retail investors.
When you buy / sell ETFs in the stock exchange, the transactions will take place on the basis of the market price (buy / sell price) and not the Net Asset Value (mutual fund NAV) of the ETF. The market (buy / sell) price of an ETF may be different from the NAV. The difference between the market price and NAV depends on the liquidity of the ETF. ETFs that are highly liquid, trade at prices that are close to NAV. If liquidity is low, then market prices may diverge from the NAV.
Points to consider when you invest in Exchange Traded Funds
1. Total Expense Ratio (TER)
The costs incurred by AMCs to provide services like fund management, administration etc. are charged as fee to the unit holders to defray the expenses. TER is the ratio such expenses / fees as a percentage of mutual fund scheme’s Net Asset Value. Since ETFs aim to track the index, an ETF with lower TER will outperform an ETF with higher TER. You should try to invest in ETFs with lower TERs.
2. Tracking error
The tracking error of an ETF is the difference between the ETF’s returns and the benchmark index returns. TER is a major source of tracking error. Other sources of tracking errors may be delay in executing buying / selling of securities in the ETF, impact of buying / selling securities, percentage of cash held by the ETF etc.
3. Liquidity
Since retail investors usually have to buy / sell their ETF units in the stock exchanges, liquidity should be an important consideration, while investing in ETFs. If your ETF is not highly liquid you face challenges selling your ETF units at the right price in extreme market conditions.
Also read: Should You Buy IPO-bound Stocks From Unlisted Markets?
