In the domestic context, despite having been in existence for a while, Exchange Traded Funds have never quite captured the investor's imagination. This is in contrast to the scenario in markets like the U.S. where ETFs are quite popular. ETFs do have a bit of a history in India.
For example, we had a close-ended fund i.e. Morgan Stanley Growth Fund (launched in 1994) which was listed and traded on the stock exchanges. Year 2001 saw the launch of India's first open-ended, passively-managed ETF, Nifty Benchmark Exchange Traded Scheme (Nifty BeES).
Since then several ETFs of different varieties have been introduced. In this article, we discuss the investment proposition offered by ETFs and how they differ from conventional mutual funds.
What are ETFs?
Simply put, an ETF is a basket of securities that is traded on the stock exchange, akin to a stock. So, unlike conventional mutual funds, ETFs are listed on a recognised stock exchange. Their units can be bought and sold directly on the exchange, through a stockbroker during the trading hours.
ETFs can be either close-ended or open-ended. Open-ended ETFs can issue fresh units to investors even post the new fund offer stage, although this tends to happen selectively on account of the substantial lot sizes involved. In case of ETFs, since the buying and selling is largely done over the stock exchange, there is minimal interaction between investors and the fund house.
Besides, ETFs can be either actively or passively managed. In an actively-managed ETF, the objective is to outperform the benchmark index. To that end, they have no obligation to invest in stocks from any benchmark index. On the contrary, a passively-managed ETF attempts to replicate the performance of a designated benchmark index.
Hence it invests in the same stocks, which comprise its benchmark index and in the same weightage. For example, Nifty BeES is a passively managed ETF with the S&P CNX Nifty being its designated benchmark index. In the Indian context, passively managed ETFs are more prominent.
How ETFs are different from conventional mutual funds
Investors often confuse ETFs with conventional mutual funds. However, the fact is that they are different on several counts. Perhaps, the only similarity between ETFs and conventional mutual funds is that they both provide investors an opportunity to invest in an assortment of stocks/instruments through a single avenue.
1) First, an investor in a mutual fund needs to buy and sell units from the fund house. In case of an ETF, the transaction has to be routed through a broker as buying and selling is done on the stock exchange. In the rare case that an investor can buy or redeem units in an ETF through the fund house, it is normally done in a pre-defined lot size. Typically, the lot size tends to be substantial making it feasible only for institutional investors and high networth individuals.
2) Since ETFs are traded on the stock exchange, they can be bought and sold at any time during market hours like a stock. This is known as 'real time pricing' as ETF investors can transact at the price prevailing at that point in time. This is in contrast to mutual funds, wherein units can be bought and redeemed only at the relevant NAV; the NAV is declared only once at the end of the day. As a result, ETF investors have the opportunity to make the most of intra-day volatility. Of course, this may hold little significance for long-term investors.
3) ETFs are associated with low expenses vis-à-vis mutual funds. For example, a passively managed ETF which tracks a benchmark index (say S&P CNX Nifty) would have an annual recurring expense in the range of 0.44%-0.50%, while it would be around 1.00%-1.25% in case of an index fund tracking the same benchmark index.
Unlike mutual funds wherein entry/exit loads can vary between 2.00%-2.25%, ETF investors do not have to bear any loads. Instead they have to pay a brokerage while transacting. While brokerage rates vary across brokers, a brokerage of around 0.50% on each transaction in the Indian context can be regarded as being on the higher side. However, ETF investors must have a demat account, this in turn entails paying an annual maintenance charge (which can be about Rs 300). Since ETF investors often invest in stocks as well, the maintenance charge of the demat account can be apportioned on both the stock and ETF investments.
4) ETFs safeguard the interests of long-term investors. The reason being that since all the buying and selling of units is done on the exchange, the fund house doesn't enter the picture. Investors directly interact with other investors over the exchange. This in turn ensures that the fund manager's hand is never forced due to the buying/selling activity.
In case of mutual funds, the possibility of a substantial redemption adversely affecting the fund cannot be ruled out. For example, the fund manager might be forced to sell his best investments prematurely to meet the redemption pressure. This in turn could have a negative impact on the long-term investors' interests.
5) While mutual funds are always available at end-of-day NAV, ETFs do not necessarily trade at the NAV of their underlying portfolio. Rather, the market price of an ETF is determined by the demand and supply of its units (which in a close-ended ETF is fixed), which in turn is driven by the value of its underlying portfolio. Therefore, the possibility of an ETF trading below (at a discount) or above (at a premium) its NAV does exist.
Clearly, despite their seemingly similar structures, ETFs and mutual funds are distinct on several fronts. As always, investors should take into account their risk appetite and investment objectives, among a host of other factors; and consult their investment advisors/financial planners to determine the suitability of ETFs in their portfolios.
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