Investing in ETFs :: Business Line,

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Not sure which stock or mutual fund to pick? Well, how about buying the market as a whole? Enter investments in exchange traded funds (ETFs).

ETFs are good investment options simply because they faithfully track the index or asset they promise to.

They are also a sure-fire way to buy the market or a certain section of it, without selecting stocks, poring over balance sheets or complicated ratios.

ETFs are also a good way to own investments you cannot track on your own.

HOW THEY WORK

ETFs are closed-end mutual funds whose units are listed and traded on the stock exchanges like shares.

The objective of an ETF is neither to do better than the index or asset it tracks nor worse. Instead, it tries to minimise “tracking error”— the difference between the fund's returns and that of the index or asset.

The manager of an index ETF cannot make bets on stocks that will zoom ahead of the market.

They only replicate its index to the minutest detail. For instance, a Nifty ETF will own the basket of Nifty stocks in exactly the same proportion as the index itself.

SHADOWING THE INDEX

How do ETFs manage to shadow the index so closely, when many other equity funds don't? Primarily, by owning a portfolio that is a carbon copy of the index.

This ensures that every stock price move that affects the index also affects the ETF the same way. And if NSE decides to tweak the Nifty index by adding a few stocks and removing others, the managers of Nifty ETFs will do exactly the same to their portfolios.

Secondly, ETFs also have other inbuilt checks to ensure that their market price doesn't stray too far away from their underlying value.

Small investors can only buy ETF units on the stock exchanges. But large ones (read institutions) have the option of buying chunks of an ETF in the form of “creation units”, by tendering shares or the underlying asset, in kind. The constant barter of physical assets for an ETF's units ensures that the fund's price doesn't stray too far away from the asset it reflects.

WHY BUY

One, ETFs allow you to buy costly assets or an entire basket of stocks in bite-sized portions.

Two, among the various mutual fund options, ETFs are the cheapest to own. Open-end equity funds usually charge you about 2.25 per cent a year for managing and running the fund, which comes out of your own returns. An ETF comes at a much lower 0.50 per cent yearly charge (you would however incur brokerage on buying units). Besides, you also don't run the risk of your fund manager holding a lot of cash and missing the bus!

Three, ease of transaction. As ETFs can be bought through your online stock trading account, you needn't set up a separate account with a fund house or find a separate advisor to buy or sell ETF units. You can also buy or sell ETF units intra-day, not possible with open-end funds.