Monday, May 13, 2013

Exchange Traded Funds

This article was originally published in Postnoon on May 9, 2013

Regarded as the most revolutionary alternative investment instrument, Exchange Traded Funds or ETFs have evolved rapidly in the last few decades. However, despite proving their effectiveness globally, ETFs are yet to make a stronghold in India.

What Are ETFs?

ETFs are index funds that, like stocks, are traded on the stock exchange; but unlike stocks, they are the shares of a portfolio and not of a particular company. Like mutual funds (MFs), ETFs represent a collection of stocks; but unlike MFs, they are traded throughout the day. ETFs closely track the performance of different market indices during the trading day. Unlike closed-ended funds, they do not have a limited number of shares. An ETF’s trading value is based on the market price of the underlying stocks in the target index, like a Nifty ETF will look to replicate CNX Nifty returns.


ETFs can be traded real time during market hours as well as in advance. Since they are a passive investment tool with low turnover, ETFs, compared to active MFs and closed-ended funds, have a lower expense ratio and transaction cost. They do not impose backend redemption charges. Adding to the attractiveness of ETFs is their high diversification quotient, simplicity and transparency. In ETFs the underlying stocks are known and quantities are already defined. Investment in ETFs can be directly made through the fund house or the stock exchange. Unlike MFs, ETFs report holdings on a daily basis and transact based on the market price. They are tax efficient as they seek to minimize capital gains by exchanging the stocks that are sold out of the index with those funds that are added to it. ETFs are a good choice for new investors with a small corpus. The minimum ticket size is 1 unit (in case of IIFL Nifty ETF, 1 unit is approximately 1/10th of the Nifty level, that is INR 500, when Nifty is at 5000).


These advantages notwithstanding, ETFs have certain demerits that have derailed their growth in India. ETF investments are limited to narrow-based market indexes and some of them result in higher costs and risks as they do not track the widely accepted indexes. With ETFs being limited to large-cap stocks in some countries, investors could be deprived of gains from investments in mid/small-cap stocks. Compared to actual stocks, ETF investments are generally made in a low volume index, which could result in a higher bid-ask spread. Further, ETFs, like stocks, cannot be wilfully sold if it is a thinly traded issue or if the market is experiencing high volatility.

These might explain why ETF investments, though attractive, have yet not found a significant place on the investment bandwagon in India.
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