What is an exchange-traded fund (ETF)? How do ETFs work?

What is an exchange-traded fund

Exchange traded funds are investment instruments having the most sought-after attributes of both stocks and mutual funds. While mutual funds are famous for the diversification benefit they provide, shares remain a hot property because they are highly liquid and can be freely traded.

Exchange-traded funds get you the best of both these worlds, i.e., they can be traded on an exchange like stocks and provide the benefit of diversification like mutual funds.

Let us understand how this instrument works.

Understanding Exchange Traded Funds

ETFs are a collection of securities that can be traded on stock exchanges like normal stocks. They can also be a combination of similar securities as well as heterogeneous securities. Usually, ETFs are created to track popular indices or sectors, but it is possible to find stocks, bonds, real estate, commodities, currencies and debentures etc., in the form of exchange-traded funds as well. Basically, any asset class that has an established index can be crafted into an ETF.

To learn more about different asset classes and how you can expand your portfolio, read our beginners guide on asset allocation in the Teji Mandi blogs.

Like share prices, the trading price for exchange-traded funds is determined by market buying and selling forces.

When you buy an ETF, you invest in the securities that the ETF has invested in, much like with mutual funds. The fluctuations in the prices of ETFs can be attributed to the changes in the price of the underlying securities the fund has invested in. If the majority of the invested securities are trading with a positive bias (seen in the upward movement of the index the ETF tracks), the ETF’s price will go up in line, and the converse is also true.

ETFs too can be actively or passively managed. In actively managed funds, portfolio managers are designated with duties of accessing the fund’s performance at all times and making calculated adjustments to drive in more returns. While in the case of passively managed funds, there is not much rebalancing happening. The strategy is pre-decided and choice securities are chosen for investment based on which index they want the ETF based off.

While ETFs may seem similar to mutual funds, there are fundamental differences between the two. Let us understand this in detail.

How are ETFs different from mutual funds?

Though ETFs mimic mutual funds on several fronts, like allowing investors to buy multiple securities with a single investment and getting the diversification benefits, ETFs still have some key differences.

Exchange traded funds are highly liquid instruments like stocks, and can be freely traded during the market hours. The unit price, called the NAV, as is with mutual funds, changes by the minute like it does with stocks as forces of demand and supply act out during the trading session. On the other hand, the NAV of a mutual fund is decided at the end of the day based on the closing price of the underlying securities that comprise the mutual fund.

Buyers of ETFs can exercise features like placing limit orders, stopping losses, target prices, etc., that you get with shares; however, only plain vanilla buying and selling is possible in the case of mutual funds.

Moreover, ETFs don’t have a minimum investment criteria like mutual funds, and you can buy as low as one share of an ETF.

How do ETFs work?

Now that we know ETFs provide exposure to a basket full of securities with a single investment let’s understand how they work.

Talking about their constitution, ETFs are like units of mutual funds, except that they can be traded on exchanges during market hours.

Here’s how ETFs work:

  • The ETF provider creates a basket of securities and gets it registered with SEBI. The creator solely reserves the right to select the securities. The provider then offers the ETF to investors, and collects their investments, and stakes these investments in the units of the ETF.
  • Buyers get units of the ETF just like they buy any mutual funds. Note that you do not directly own the securities the ETF has invested in, and only own a portion of the ETF that holds those securities.
  • Does that mean buyers are not eligible for any dividends paid out by such companies? No, the dividends distributed by the pooled securities will be reflected in the earnings of the ETFs.
  • Next, the buyers and sellers are allowed to trade the exchange-traded fund units on recognized exchanges just like ordinary shares.

Here, it becomes helpful to understand the concept of ‘market makers’.

Market makers are designated firms that the stock exchange appoints to ensure there’s liquidity in the ETF market. This is done by the market makers by providing two-way quotes (both buy and sell) for a number of shares that are guaranteed. If you, as a buyer, apply for the ETF, the market maker immediately completes the order by selling the shares that he has. Because of this, the execution time of the deal significantly reduces, allowing the trade of a larger number of shares. This improves the liquidity. Moreover, this procedure also ensures that transactions are quoted at a fair market price, and buyers or sellers are not forced to pay high premiums.

Let us now look at the main features of ETFs.

Features of ETFs

ETFs have the following features:

Diversification:

ETFs allow investors to diversify their portfolios across verticals, geographies, sectors, industries, etc. Your risk gets spread across the different securities in the basket, so if one security has a bad year, the others will make up for it.

When investing in ETFs, you don’t have to worry about diversifying your portfolio on your own. ETFs themselves have so many diversified assets in their basket.

Learn more on how diversification can help you get better returns at minimal risk in our blog on stock investing in India – what is diversification of portfolio.

Transparency:

ETFs are a nod ahead of mutual funds when it comes to transparency and public disclosure.

Holdings of an ETF are disclosed every day post-market hours, unlike mutual funds, where the disclosure comes once a month. Moreover, the latest price activity of ETFs is updated every minute.

Tracking error:

This is the way devised to evaluate the performance of the ETFs. In the case of index ETFs, the returns of the ETF are compared against the returns of the benchmark index, and any bias results in tracking error. When ETFs start delivering tracking errors near zero, the same is considered an efficient one. Cases where a positive tracking error arises indicate that the ETF performs better than the benchmark.

Trading and commission costs:

You might have to pay slightly higher to own an ETF than to own a mutual fund. In the case of mutual funds, your costs are limited to the extent of the expense ratio of the fund. However, you will have to pay commission and brokerage fees when you buy and sell ETFs in ETFs.

Let us now explore the types of ETFs that are popular.

Types of ETFs

While the modus operandi remains the same, ETFs are differentiated on the basis of securities they invest in. Some of these are as follows:

Index ETFs

They track a particular benchmark index; it pools all the stocks in the benchmark index in the same proportion as in the index. For example, someone investing in the Nifty ETF will have exposure to all stocks within the Nifty in the exact same proportion as in the Nifty itself. Investors who look to stay in the equity markets but with a cushion of diversification may explore Index ETFs as options.

Now, one might wonder what is the need for Index ETFs when there are Index mutual funds?

The answer is – to rule out the limitations of index mutual funds. This includes constraints like post-market hours price discovery, minimum investment criteria, non-availability of limit or stop orders, etc.

Industry/sector ETFs

These ETFs are created to track a particular sector or industry of the market. For instance, the telecom sector, the EV sector, the energy sector, the IT sector, the banking industry, etc.

It’s a perfect fit for investors who are particularly bullish on a specific sector rather than the market as a whole, but at the same time don’t want to invest only in selected stocks of the sector. Such investors can buy sector ETFs to spread their money across all the stocks in the sector.

Bond ETFs

Bond ETFs are a good source for investors eyeing passive income. Bond ETFs invest in government bonds, corporate bonds, and other state and local bonds.

Commodity ETFs

Commodity ETFs are finding popularity among commodity investors as owning them is a lot cheaper and more convenient than owning the actual commodities. Commodity ETFs can be crafted around commodities like gold, crude oil, base metals, etc., tracking the prices of these commodities in the market.

Generally, commodity ETFs are bought as a hedge against equity markets so that when there’s a bull dominant equity market, some sort of cushion can be found from commodities.

Inverse ETFs

Inverse ETFs are a perfect example of how creative ETFs can be. Just like we have the luxury of going short in the equity markets, you can also benefit from stock declines in ETFs.

Inverse ETFs use derivative contracts to go short on the combined securities, and eventually, when the markets decline, the ETF prices rise.

An inverse exchange-traded fund can be used as a hedge against your normal ETFs. You can buy it in smaller proportions to limit your downside risks. Please note here that inverse ETFs aree not permitted in India. There are indian index based inverse ETFs, but they are operational in foreign countries such as Hong Kong and China.

Now that we know ETFs provide exposure to a basket full of securities with a single investment let’s understand how they work.

Things to consider while investing in ETFs

Before investing in an ETF, make sure you are thorough with your research and keep the following things in mind:

Do not treat ETFs like normal stocks

ETFs can indeed be traded just like normal stocks; it is permissible to trade ETFs intraday. However, ETFs are essentially long-term investment products.

We have seen individual stocks outperforming indices/sectors. In the long run, ETFs, at their best, can maintain a sync with the indices/sectors, but outperformance is not possible given they simply track the indices, not try to outrun them.

The age of the ETFs

The older the ETF is, the more information is available on it. This will allow you to assess its performance based on how it has traded over the years, the growth it has shown, and the return it provides. That doesn’t mean new ETFs are not worth investing in. With proper insight into its features, you can assess the growth prospects of an ETF and secure a fruitful investment.

Holdings

You can check the disclosure issued by ETFs to know the securities the ETF invests in. Invest only if it serves your purpose and suits your trading style.

Liquidity

If the ETFs are not liquid, you’ll find it challenging to trade in them. The best way to assess the liquidity of an ETF is to check its bid-ask spread. The thumbs rule says the minimum, the better. Because higher bid-ask spread means buyers and sellers are quoting prices where they don’t agree to transact.

Conclusion

ETFs are an exciting tool for investment that amalgamates features of stocks and mutual funds into one product. It provides a low-cost entry to diversified equity and may be good investments if held for the long term. ETFs are fast gaining popularity though are still nascent in India.

Experts at Teji Mandi do extensive research to fetch you the latest market updates and the best investments that suit your financial goals. What to start investing in ETFs? Reach out to us on our website!

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