What are ETFs and how do they work?

ETFs

What are ETFs and how do they work?

Exchange traded funds (ETF’s) are a form of Index mutual funds that trade on stock exchanges like NSE and BSE. Here, for example, Nifty BEES is an Exchange-traded fund that is traded on exchanges like a stock at the same time tracks nifty as an index fund.

How to buy ETFs?

Since ETFs are traded on exchanges like stocks they cannot be bought like regular mutual funds, hence you need to open a demat account with a stockbroker and buy the ETF’s in the exchange just like buying shares.

Expenses

Since ETF’s are normally exchange traded they incur less expense ratio than mutual funds and there are funds like HDF Nifty ETF that offer expense ratio as low as 0.05%. However, there are other charges such as AMC charge for the demat account which would be around ₹500 on an average and also the investor needs to pay brokerage for buying and selling of the units which would together come around 1% of the transaction value.

Pricing

The NAV of the index funds is determined at every end of the day regularly just like regular mutual funds. However, the ETF prices are real time just like the stocks.

Investment Value

Since ETFs are like stocks and are traded on exchanges the minimum investment value depends on the unit price, however at least 1 unit should be purchased. For example, SBI Banking ETF has a NAV Value ₹254 (As on 02/12/2017) and hence Minimum investment value will be ₹254. In general, there are no SIP programs available to purchase ETFs, however certain stock brokers allow their customers to configure SIPs for stocks/ETFs with a condition that the required amount should be available on their trading/demat account.

Liquidity

The ETFs are similar to closed-ended mutual funds where the AUM size is fixed during the NFO and there wouldn’t be any change in it until there is another offer for sale which may or may not be held. So whenever you buy an ETF unit on an exchange it is a unit sold by another person. Hence the liquidity of the fund depends on the fund’s transactional volume in exchanges. However when you sell an ETF maximum time taken for the money to reach your bank account will be 2 days.

Tracking Error

ETFs have very less tracking error in tracking their index because the amount of cash they hold for creating liquidity is lesser than an index fund. The lesser the tracking error, lesser the deviation of returns on (both upper and lower side) will be less. Also, ETFs disclose their holdings on a daily basis

Taxation

ETFs have exactly the same tax structure as Index mutual funds; however, the investor has to pay Securities Transaction Tax of 0.125% in addition to regular tax logic.

Options

In case of ETFs, it’s only one option that is growth option.

Advantages of ETFs

  1. High liquidity as the prices and trade happen at real time through stock exchanges
  2. Expense ratios are even lower than Index mutual funds
  3. Like Index mutual funds ETF’s also doesn’t have many dependencies on fund manager.
  4. Similar to Index mutual funds ETFs are less volatile than actively managed mutual funds.
  5. Investment amount is very low and ETF’s can be bought as low as 1 unit.

 Disadvantages of ETFs

  1. You need to provide brokerage to your stockbroker for buying and selling ETF’s. Also, you will have to pay an AMC for your DP. These charges could end up higher than the expense ratio in index mutual funds.
  2. Since ETF’s are similar to closed-ended mutual funds, there won’t be any new units and hence only when someone sells you their units you can buy on stock exchanges. Also the same will be applicable to selling as well.
  3. While buying and selling ETF’s an additional tax, STT (Securities Transactions Tax) has to be paid.

ETFs have more shortcomings than advantages in current Indian markets, hence we suggest to go for Mutual funds and avoid ETFs.

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