Exchange Traded Funds (ETFs)

ETFs, Exchange Traded Funds are growing in popularity in the Indian markets. Abroad, these funds have become a vital part of the portfolio of investors. To give you an approximate, these funds, form 60% of the trading volume on the NYSE MKT LLC (formerly known as American Stock Exchange). Retail Investors can look to invest in these funds to meet their investment objectives but they should first try to educate themselves about the product.

Before moving deeper, we would first like to introduce the reader to concept of ETFs and what they are. ETFs are exchange traded funds that track the prices of the underlying assets. The assets could be a commodity such as Gold, or could be stocks of a certain Index or even be a number of stocks whose prices will be tracked by the ETF. For example an ETF such as the GS CPSE ETF tracks the price of a few listed CPSEs of India. So if an investor purchases Gold ETFs, the market price of the units will track the price of Gold. The investor should be very clear that the market price and NAV of the ETF track the price of the underlying asset but the investor purchases the units at the market price and not the NAV. This has been explained in greater detail below.

How do ETFs work?

Now one must wonder how do these funds work or how one can participate in these funds to make investments into these. These funds, in functionality, are quite different from Mutual Funds. Let us explain this very briefly.

The fund houses have hired or appointed market makers who have the role of creation of units of the ETFs. Suppose a Fund House has to launch an ETF tracking the Nifty 50 index. The market maker would purchase the stocks of the Nifty 50 (in the same proportion as they constitute the index) and exchange the same for units of the same from the Fund House. This process is termed Unit Creation whereby the market makers create the units of the ETF. These units are then broken and listed on the exchange where they can be purchased or sold. This activity is usually carried out by a Fund House due to the huge sums of money that is required to create the minimum number of units for launching an ETF.

Investors can then purchase and sell these ETFs directly from the Exchange. ETFs too have a NAV and a market price. The market price generally is in the range of 0.1%-2% of the NAV of the units. The reason for the disparity in the ETF price and its NAV is usually the liquidity of the same. We have seen some scenarios where the ETF has very thin volume (as low as 10 units traded in a day) and the disparity between the same ETF’s NAV and market price is as high as 8.5%. So it is very important for the investor to check the liquidity of the underlying security. Abroad, where the liquidity is high in the trading of ETFs, the difference between the price and the NAVs is between 0.1%-0.5%.

How does an investor invest?

When an investor purchases an ETF, in effect, he/she buys the units of the ETF (at the market price of these units). That is why we suggest the investor to check the liquidity as it will have an impact in the premium or discount that he will receive as compared to the NAV of the ETF.

ETFs in India are currently available in Equity, Debt, Global Indices and Gold. These are traded on the NSE and BSE. Within the Equity segment ETFs could be of certain indices or a group of stocks that are traded on the exchange. So if an investor wants to purchase a Nifty50 ETF, he or she can do so by buying the units from the NSE or BSE. Once an investor is confident about the asset he wants to purchase through ETF (units) he will have to choose the Fund House, check the liquidity of the product & purchase it at the market price listed.

Advantages of ETFs

• For assets such as Gold, the investor need not have to rely solely on future contracts available on the Commodity indices. They can invest in Gold through ETFs now. Even in the case of the Indices. I can participate in the US markets through the GS Nasdaq ETF that tracks the performance of the top 100 companies on the NASDAQ.
• The ETFs have a very low expense ratio as compared to Mutual Funds. It varies across all fund houses. Usually, in India the range is from 5 basis points to 8.5 basis points. But the point to note is that ETFs will have a commission paid to the service provider/broker.
• Easy transaction process. Purchase and Sale of units of ETFs is similar to buying and selling of shares on the exchange.
• If the ETF is liquid enough, it can be bought and sold during market hours.
• No separate form filling required.
• Ability to place limit orders