Exchange Traded Funds (ETFs)

What is an ETF?

An ETF, or exchange traded fund, is a marketable security that tracks an index, a commodity, bonds, or a
basket of assets like an index fund.

In the simple terms, ETFs are funds that track indexes such as CNX Nifty or BSE Sensex, etc. When you
buy shares/units of an ETF, you are buying shares/units of a portfolio that tracks the yield and return of
its native index. The main difference between ETFs and other types of index funds is that ETFs don't try
to outperform their corresponding index, but simply replicate the performance of the Index. They don't
try to beat the market, they try to be the market.

Unlike regular mutual funds, an ETF trades like a common stock on a stock exchange. The traded price of
an ETF changes throughout the day like any other stock, as it is bought and sold on the stock exchange.
The trading value of an ETF is based on the net asset value of the underlying stocks that an ETF
represents. ETFs typically have higher daily liquidity and lower fees than mutual fund schemes, making
them an attractive alternative for individual investors.

Passive Management
ETFs are passively managed. The purpose of an ETF is to match a particular market index, leading to a
fund management style known as passive management. Passive management is the chief distinguishing
feature of ETFs, and it brings a number of advantages for investors in index funds. Essentially, passive
management means the fund manager makes only minor, periodic adjustments to keep the fund in line
with its index. An investor in an ETF do not want fund managers to manage their money i.e., decide
which stocks to buy/sell/ hold), but simply want the returns to mimic those from the benchmark index.
Since buying all scrips that are part of say, the Nifty (which has 50 scrips) is not possible, one could
invest in an ETF that tracks Nifty.

This is quite different from an actively managed fund, like most mutual funds, where the fund manager
‘actively’ manages the fund and continually trades assets in an effort to outperform the market.

Because they are tied to a particular index, ETFs tend to cover a discrete number of stocks, as opposed
to a mutual fund whose scope of investment is subject to continual change. For these reasons, ETFs
mitigate the element of "managerial risk" that can make choosing the right fund difficult. Rather than
investing in an ‘active’ fund managed by a fund manager, when you buy shares of an ETF you're
harnessing the power of the market itself.

ETFs are cost-efficient

Because an ETF tracks an index without trying to outperform it, it incurs lower administrative costs than
actively managed portfolios. Typical ETF administrative costs are lower than an actively managed fund,
coming in less than 0.20% per annum, as opposed to the over 1% yearly cost of some actively managed
mutual fund schemes. Because they have lower expense ratio, there are fewer recurring costs to
diminish ETF returns.

What are the costs of investing in ETFs?

While the Expense Ratio of ETFs is lower, there are certain costs that are unique to ETFs. Since ETFs are
bought traded on stock exchange through a stock broker, every time an investor makes a purchase or
sale, he/she pays a brokerage for the transaction . In addition, an investor may also incur STT and the
usual costs of trading in stocks, including differences in the ask-bid spread etc. Of course, traditional
Mutual Fund investors are also subjected to the same trading costs indirectly, as the Fund in turn pays
for these costs.

Flexibility of ETFs
ETF shares trade exactly like stocks. Unlike index funds, which are priced only after market closings, ETFs
are priced and traded continuously throughout the trading day. They can be bought on margin, sold
short, or held for the long-term, exactly like common stock.

Yet because their value is based on an underlying index scrips, ETFs enjoy the additional benefits of
broader diversification than shares in single companies, as well as what many investors perceive as the
greater flexibility that goes with investing in entire markets, sectors, regions, or asset types. Because
they represent baskets of stocks, ETFs typically trade at much higher volumes than individual stocks.
High trading volumes mean high liquidity, enabling investors to get into and out of investment positions
with minimum risk and expense.

What are the benefits of investing in ETFs?

ETFs combine the range of a diversified portfolio with the simplicity of trading a single stock. Investors
can purchase ETF shares on margin, short sell shares, or hold for the long term. ETFs can be bought /
sold easily like any other stock on the exchange through terminals across the country.

Asset Allocation: Managing asset allocation can be difficult for individual investors given the costs and
assets required to achieve proper levels of diversification. ETFs provide investors with exposure to broad
segments of the equity markets. They cover a range of style and size spectrums, enabling investors to
build customized investment portfolios consistent with their financial needs, risk tolerance, and
investment horizon. Both institutional and individual investors use ETFs to conveniently, efficiently, and
cost effectively allocate their assets.

Cash Equitisation:
Investors typically seek exposure to equity markets, but often need time to make investment decisions.
ETFs provide a "Parking Place" for cash that is designated for equity investment. Because ETFs are liquid,
investors can participate in the market while deciding where to invest the funds for the longer-term,
thus avoiding potential opportunity costs. Historically, investors have relied heavily on derivatives to
achieve temporary exposure. However, derivatives are not always a practical solution. The large
denomination of most derivative contracts can preclude investors, both institutional and individual,
from using them to gain market exposure. In this case and in those where derivative use may be
restricted, ETFs are a practical alternative.

Hedging Risks:
ETFs are an excellent hedging vehicle because they can be borrowed 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.
Arbitrage (cash vs futures) and covered option strategies:
ETFs can be used to arbitrage between the cash and futures market, as they are very easy to trade. ETFs
can also be used for cover option strategies on the index.