What is ETF?

Exchange Traded Funds (ETFs) are baskets of stocks that reflect the composition of a market index, like the Sensex or the Nifty. ETFs are listed and traded on stock exchanges like stocks. To invest in ETFs you need to have demat and trading account with a stock broker. While ETFs are similar to mutual funds in many ways, there is a fundamental difference in the objectives of ETFs and actively managed mutual funds. While actively managed funds aim to generate alpha by outperforming a market benchmark, whereas ETFs aim to track the relevant index and replicate it returns subject to tracking error.

 

What are Index Funds?

Index funds are passively managed mutual fund schemes which invest in baskets of stocks with the aim of replicating a market index just like ETFs. Unlike ETFs, you do not need a demat account to invest in mutual funds. You can invest and redeem your index fund units with the AMC either directly or through your mutual fund distributor.

How to select ETFs and Index Funds?

There are mainly four parameters which investors should look at while investing in ETFs:-

• Total Expense Ratio (TER): Lower the TER, higher will be the ETF returns compared to a higher TER ETF
• Tracking error: Tracking error is the deviation between index return and the ETF return. This is an important performance parameter because as an investor you are actually investing in the index.
• Liquidity: This is an extremely important factor for ETFs because unlike mutual funds, ETFs are bought and sold in the stock exchanges. If an ETF is not very liquid, you may not find enough buyers when you want to sell your ETFs.

ETF Categories

Some of the popular ETF category schemes are as follows:-

• Index ETF, the most common of all ETF product offerings, aims to track a particular market index like Sensex, Nifty etc.
• Gold ETF which aims to track the price of gold in the market and has the same value as that of pure 24 carat physical gold.
• International ETF invests mainly in a basket of international securities tracking global markets or country-specific benchmark indices. These ETFs are good investment options to get global exposure.
• Liquid ETF which invest in a basket of short term Government securities, call money or money market instruments of short term maturities.

Why invest in ETFs or Index Funds?

• No unsystematic risk: Actively managed funds will be overweight or underweight on some stocks / sectors relative to the market benchmark index because they want to beat the index. This results in unsystematic risks i.e. risk over and above market risk. More than 50% of the funds in several categories have not been able to beat market benchmark in the last 1 to 3 years (source: Advisorkhoj research). There is no unsystematic risk in ETF. You will get the index returns subject to tracking error.
• Focus on high performers: The indices, which by their method of construction based on market capitalization, reduce the weight of underperformers in the index. By extension ETFs also reduce the weight of underperformers in their portfolio and have the potential of providing superior returns.
• Low cost: The expense ratio of ETFs is much lower than their mutual fund counterparts. The difference in cost can result in substantial difference in absolute returns in the long term.
• Simplicity: You do not have to analyze past performance, understand fund manager’s investment style or how the fund has done across different market conditions. You can simply select an index and invest in a low cost ETF, which tracks that index and your job is done.