Exchange Traded Funds Demystified

An exchange-traded fund (ETF) is an investment fund traded on a stock exchange, much like stocks. An ETF holds assets such as stocks, commodities or bonds and trades at approximately the same price as the net asset value of its underlying assets over the course of the trading day.

ETFs offer investors an undivided interest in a pool of securities or assets and thus are similar in many ways to traditional mutual funds except that shares in an ETF can be bought and sold throughout the day like stocks on an exchange. Unlike traditional mutual funds, ETFs do not sell or redeem their individual shares at net asset value or NAV.

ETFs had their genesis in 1989 with Index Participation Shares, an S&P 500 proxy that traded on the American Stock Exchange and the Philadelphia Stock Exchange. India joined the ETF club in December 2001 with the launch of India's first ETF 'Nifty BeES' based on the S&P CNX Nifty Index by Benchmark Mutual Fund.

ETFs provide the easy diversification, low expense ratios and tax efficiency of index funds while still maintaining the features of ordinary stock. Because ETFs can be economically acquired, held and disposed of, some investors invest in ETFs as a long-term investment for asset allocation purposes while other investors trade ETF shares frequently to implement market timing investment strategies.  

Among the advantages of ETFs are:

• Lower costs - ETFs generally have lower costs than other investment products because
  1. Most ETFs are not actively managed
  2. ETFs are insulated from the costs of having to buy and sell securities to accommodate    shareholder purchases and redemptions.
  3. ETFs typically have lower marketing and distribution costs.
     Mutual funds can charge 2.50%; index fund expense ratios are generally lower while ETFs are almost always in the 0.1% to 1% range. Over the long term, these cost differences can compound into a noticeable difference.
• Buying and selling flexibility - ETFs can be bought and sold at current market prices at any time during the trading day unlike mutual funds  where the price is known only at end of the day.
• Market exposure and diversification - ETFs provide an economical way to rebalance portfolio allocations and offer exposure to a diverse variety of markets, countries and asset classes. An index ETF inherently provides diversification across an entire index

Their critics point out these shortcomings:

• John C. Bogle, founder of The Vanguard Group, a leading issuer of index mutual funds (and since Bogle's retirement, of ETFs), has argued that ETFs represent short-term speculation, that their trading expenses decrease returns to investors and that most ETFs provide insufficient diversification. He concedes that a broadly diversified ETF that is held over time can be a good investment.
• Exchange traded funds have a cost each time a trade is made in the form of a brokerage commission.
• Another concern is that the funds trade on the market, and therefore may not always be trading at the underlying net asset value. Research into pricing of ETFs has generally concluded that discrepancy if any is minor and usually lasts only for a short period of time. The risk of pricing errors is much higher in funds that do not trade regularly such as certain foreign ETFs.

Actively managed funds Vs. ETFs

The portfolio manager of an actively-managed fund tries to beat the market by picking and choosing investments. The manager performs an in-depth analysis of various investments in an attempt to outperform the market index like the NIFTY.

The potential to outperform the market is one advantage that actively-managed funds have over ETF and this expectation of outperformance is attractive to investors. Unfortunately, based on evidence in overseas markets, it is difficult to conclude that actively-managed funds can consistently outperform their relevant index. It’s even more challenging for distributors and investors to identify which actively-managed fund will outperform the index in a given year.

Cafemutual’s recommendation:

Indian ETFs

1. Ideal for those willing to invest in stock markets but not bear fund performance risk.
2. So far, actively managed equity funds have done well. Allocate a higher sum to them.