Mutual funds are great. They provide retail investors an indirect option to participate in the stock market. They are expertly managed, convenient and affordable.
But mutual funds do have a critical flaw. Mutual Funds can be bought and sold only through fund houses. Like shares, you cannot buy and sell mutual funds on the stock exchange.
This major flaw led to the emergence of ‘Exchange Traded Funds, or ETFs’.
What is Exchange Traded Funds?
An Exchange Traded Fund is a collection of stocks, which are traded on the stock exchange.
This collection of stocks is as per a particular benchmark. Every Exchange Traded Fund tracks a particular benchmark. Benchmark index can be S&P 500 index, NIFTY, SENSEX etc.
There are many types of Exchange Traded Funds, based on the asset classes they track –
Exchange Traded Funds are a passive investment strategy. The goal of the fund manager is to simply copy the benchmark’s return. The fund manager does not take active investment decisions.
Now, you must be wondering, that this sounds very similar to Index Mutual Funds.
Well, you are correct!
What is the difference between Exchange Traded Funds & Index Mutual Funds? ETFs Vs. Index Funds
An Exchange Traded Fund is exactly like an index mutual fund. Both are passively managed. Both track an index. The only difference is that you cannot sell an index fund on the stock exchange.
For Example: Suppose you wanted to invest in 50 stocks of the NIFTY50 index. You have two options –
- Invest in NIFTY50 Index Mutual Fund
- Invest in NIFTY50 ETF
When you invest in NIFTY50 ETF, you can buy and sell your units anytime throughout the trading day as per your convenience.
But when you invest in NIFTY50 Index Mutual Fund, you can buy and sell only as per the day’s closing NAV.
Unlike ETFs, an index mutual fund doesn’t allow you to time the market.
What are the advantages of Exchange Traded Funds?
Here are the important advantages of Exchange Traded Funds.
1. Low Cost: The most important advantage of Exchange Traded Funds is their cost-effectiveness. Exchange Traded Funds are cheaper than index funds.
For example: HDFC Gold Fund’s expense ratio is 0.62%. But the expense ratio for HDFC Gold ETF is 0.59%.
Both HDFC Gold Fund and HDFC Gold ETF track the same stocks, but still there is a difference of 0.03%. This small difference can lead to huge losses in the future.
Hence, if you are planning long term investments, then you should invest in ETFs, not index funds.
2. Exit Loads: Another important advantage of Exchange Traded Funds is the absence of exit loads.
Exit load is a penalty that the fund house charges you if you exit a scheme before a particular time period.
HDFC Gold Fund has an exit load of 2% for redemption within 180 days. For redemption between 181 – 365 days, it charges 1%.
But HDFC Gold ETF has no exit load. You can buy and sell HDFC Gold ETF within days and you will not have to pay any exit loads.
So, if you are an active trader, then you should invest in Exchange Traded Funds rather than index funds.
3. Timing the Market: Exchange Traded Funds help investors time the market.
For example: Suppose you wanted to sell NIFTY Bees at 11 am when the stock market was up by 500 points. You put in a sell order and the same is executed immediately. The day ends with the markets down by 150 points. Irrespective of the market falling, you made a profit by selling at a particular price point.
This wouldn’t have happened in mutual funds. In mutual funds, your selling price is as per the day’s closing, even if you place the order in the morning.
Exchange Traded Funds are perfect for traders who wish to time the markets.
4. Tax Efficient: When an ETF buys and sells stocks, it does not incur taxes. In mutual funds, the profits made by the scheme is taxable. Also, since actively managed funds constantly churn their portfolio, they end up paying higher capital gains tax than ETFs
What are the Disadvantages of Exchange Traded Funds?
1. Cost: You need to open a Demat account to invest in ETFs. Certain traditional brokers charge extremely high brokerage costs. This reduces the overall portfolio returns.
2. No SIP Option: Investors cannot register SIPs in ETFs. So, if you plan to invest in HDFC Gold ETF every month, then you will have to manually make the purchase every month. This leads to an undisciplined investment approach.
3. Higher returns: Since ETFs are passively managed, they can only track the benchmark’s return. They cannot beat the benchmark returns or take advantage of the fund manager’s investment decisions. The results in substantially lower returns compared to actively managed mutual funds.
What are the different types of Exchange Traded Funds?
1. Equity ETFs: Equity ETFs invest in collection of equity shares tracking an index. NIFTY ETFs are fairly popular in India. ICICI Prudential NIFTY ETF, Kotak NIFTY ETF are examples of equity ETFs in India.
2. Gold ETFs: Gold ETFs are a type of commodity ETFs. They help investors invest in physical gold without taking physical delivery of the gold. Instead, each unit represents certain grams or tolas of gold. You can invest in gold ETF with as little as Rs 50. The net asset value of Gold ETFs and the price of gold go hand-in-hand. When the price of physical gold increases, the NAV of gold ETF also increases.
3. Liquid ETFs: Liquid ETFs invest in ultra short term government securities such as treasury bills, short term bonds, call money etc. Usually the government fixed income market is dominated by big banks, but through liquid ETFs, even small retail investors can invest in government securities.
4. Fixed Income ETFs: These exchange traded funds invest in short term to long term fixed income securities like corporate bonds, gilt securities etc. Fixed income ETFs are the perfect alternative to medium/long duration debt funds.
5. Bank ETFs: Bank ETFs invest in a basket of bank stocks listed on the exchange. Bank ETFs are highly volatile but also provide high liquidity. SBI ETF – NIFTY Bank, Nippon India ETF PSU Bank Bees are some of the Bank ETFs in India.
6. International ETFs: International ETFs invest in foreign securities. They offer overseas diversification to the portfolio. Also known as Global ETFs, they help domestic investors take advantage of overseas companies. Motilal Oswal’s MOSt Shares NASDAQ 100 is an international ETF.
7. Currency ETFs: INR (Indian Rupee) ETF allows investors to get exposure to the foreign currency market. Wisdom Tree Indian Rupee Strategy ETF & Market Vectors Indian Rupee/U.S. Dollar ETN are example of Currency ETFs.
How are Exchange Traded Funds Taxed?
Exchange traded funds follow similar taxation to mutual funds.
|Equity ETFs||Debt/Gold ETFs|
|Holding Period||12 months||36 months|
|Short Term Tax||Flat 15%||As per income tax slab|
|Long Term Tax||10% above 1 Lakh||20% with indexation|
An important concept in Exchange Traded Funds is – Tracking Error
What is Tracking Error in ETFs?
A tracking error is the difference between ETF returns and its benchmark return. For example: Suppose the return generated by NIFTYBEES is 10.23%. The return generated by the NIFTY Index is 10.25%. In this case, there is a tracking error of 0.02%.
Ideally the tracking error in exchange traded funds should be minimum. This is because the fund is only copying its index. So, its returns should also match the index’s return.
A high tracking error implies that it is an actively managed ETF. When investing in exchange traded funds, investors should stick to ETFs with low tracking error.
Popular ETFs in the World
- QQQs: Also known as Cubes, these track the NASDAQ100 index. It is one of the most liquid ETF in the world.
- iShares: The iShares ETF tracks 17 emerging markets of the world. iShares tracks the Morgan Stanley Capital International (MSCI) Index.
- TRAHK: This ETF is listed on the Hong Kong Stock Exchange and tracks the Hang Seng Index.
- SPDRs: These ETFs are traded on NYSE Arca Major Market Index and track the S&P 500.
How can you invest in Exchange Traded Funds?
Exchange traded funds are bought and sold on a stock exchange. To trade in exchange traded funds, you need to compulsorily open a Demat and trading account with a SEBI registered broker.
Similar to placing a buy and sell order for stocks, you can buy and sell ETFs throughout the trading day.
To start investing in Exchange Traded Funds, open a FREE Samco Demat account today. When you open a Samco Demat account, you get the triple benefit of: