03 March 2012

What is an ETF ? Kotak Securities explains..

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ETFs

An exchange-traded fund (ETF) is an investment fund traded on stock exchanges, much like stocks. ETFs first came into existence in the USA in 1993. It took several years for them to attract public interest. But once they did, the volumes took off with a vengeance. About 60% of trading volumes on the American Stock Exchange are from ETFs. The most popular ETFs are QQQs (Cubes) based on the Nasdaq-100 Index, SPDRs (Spiders) based on the S&P 500 Index, iSHARES based on MSCI Indices and TRAHK (Tracks) based on the Hang Seng Index.


An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or NIFTY. ETFs are attractive as an investment because of their low costs, tax efficiency, and stock-like features.

Unlike regular open-end mutual funds, ETFs can be bought and sold throughout the trading day like any stock and most ETFs charge lower annual expenses than index mutual funds. However, as with stocks, one must pay a brokerage to buy and sell ETF units, which can be a significant drawback for those who trade frequently or invest regular sum of money. However, the passive nature of ETFs is a necessity because these funds rely on an arbitrage mechanism to keep the prices at which they trade roughly in line with the net asset values of their underlying portfolios. For the mechanism to work, potential arbitragers need to have full, timely knowledge of a fund's holdings.

Types of ETFs

Index ETFs: Most ETFs are index funds that hold securities and attempt to replicate the performance of a stock market index. An index fund seeks to track the performance of an index by holding in its portfolio either the contents of the index or a representative sample of the securities in the index

Commodity ETFs: Commodity ETFs invest in commodities, such as precious metals and futures. Among the first commodity ETFs were gold exchange-traded funds, which have been offered in a number of countries

Bond ETFs: Exchange-traded funds that invest in bonds are known as bond ETFs

Currency ETFs: These funds are total return products where the investor gets access to the FX spot change, local institutional interest rates and a collateral yield.

While similar to an index mutual fund, ETFs differ from mutual funds in significant ways.
AttributeETFIndex MutualFundIndividual Stock
DiversificationYesYesNo
Traded throughout the dayYesNoYes
Can be bought on marginYesNoYes
Can be sold shortYesNoYes
Tracks an index or sectorYesYesNo
Tax efficient as turnover is lowYesPossiblyNo
Low Expense RatioYesSometimesNot a factor
Trade at any brokerage firmYesNoYes


ETFs trade like shares while providing the diversification of managed funds. Their performance closely tracks the investment returns of the shares making up the index.

Benefits of investing in ETFs

  • Convenient to trade as it can be bought/sold on the stock exchange at any time of the day when the market is open (index funds can be bought only at NAV based on closing prices)
  • One can short sell an ETF or buy on margin or even purchase one unit, which is not possible with index-funds/conventional MFs
  • ETFs are passively managed, have low distribution costs and minimal administrative charges. Hence most ETFs have lower expense ratios than conventional MFs
  • Not dependent on the fund manager
  • Like an index fund, they are very transparent


Disadvantages of investing in ETFs

  • SIP in ETF is not convenient as you have to place a fresh order every month
  • Also SIP may prove expensive as compared to a no-load, low-expense index funds as you have to pay brokerage every time you buy & sell
  • Because ETFs are conveniently tradable, people tend to trade more in ETFs as compared to conventional funds. This unnecessarily pushes up the costs.
  • You can't automatically re-invest your dividends. Secondly, you may have to pay brokerage to reinvest dividends in ETF, whereas dividend reinvestment in MFs is automatic and with no entry-load
  • Comparatively lower liquidity as the market has still not caught up on the concept

It may, therefore, be concluded that if an investor is looking for a long-term and defensive investment strategy in equities by backing the index rather than looking at active management, ETF offers an alternative to index-based funds. It offers trading convenience & probably lower costs than index funds. A case-to-case comparison is, however, important as some index-funds may be cheaper. Also for SIPs, index-funds may prove better than ETFs.

References:

1.) Actively Managed Exchange- Traded Funds, SEC Release No. IC-25258, 66 Fed. Reg. 57614 (November 8, 2001
2.) NSE
3.) Money control

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