Exchange traded funds
Invest in Exchange Traded Funds and own all stocks proportionately making up a particular benchmark index
What is an ETF?
An Exchange-Traded Fund (ETF) is a type of investment fund that is traded on stock exchanges, much like individual stocks. It combines the benefits of mutual funds and stock trading in a unique way. While similar to mutual funds in that it holds a diverse range of assets—such as stocks, bonds, commodities, or currencies—an ETF stands out because it trades throughout the day on the stock exchange, with prices fluctuating like individual stocks.
These assets are managed to replicate the performance of a specific index or investment strategy. For instance, an ETF tracking the Sensex will hold the same stocks as the Sensex Index, allowing investors to gain exposure to the entire index through a single security.
ETFs are bought and sold on stock exchanges throughout the trading day, and their prices fluctuate just like individual stocks. This feature provides investors with liquidity and flexibility, allowing them to react to market conditions in real-time. With the combination of broad diversification, low costs, and the ability to trade like a stock, ETFs offer a versatile investment option suitable for a wide range of investors.
How do ETFs Work?
ETFs work by pooling various assets, such as stocks, bonds, currencies, or commodities, into a single fund. When you invest in ETFs in India, you buy shares of this fund, which gives you exposure to the underlying assets. This approach offers a way to diversify your investment portfolio.
For example, think of ETFs as a mixed fruit basket. Instead of buying apples, bananas, and oranges separately, you buy one basket that contains all of them. Similarly, an ETF pools together different assets into a single fund.
Here’s a breakdown of how ETFs operate:
1. Creation of the ETF:
- A fund provider or asset management company selects a set of underlying assets (like a specific stock index, sector, or commodity). It creates a fund that aims to replicate the performance of these assets.
- The provider pools these selected assets into a basket, creating a portfolio that the ETF will track.
2. Issuing ETF Shares:
- Once the portfolio is established, the fund provider issues shares of the ETF. Each share represents a proportional ownership of the fund’s underlying assets.
3. Trading on an Exchange:
- The ETF shares are then listed on a stock exchange, where they can be bought and sold by investors throughout the trading day, just like individual stocks.
- The price of ETF shares fluctuates during the trading day based on market demand and supply, though it generally stays close to the net asset value (NAV) of the underlying assets due to the creation/redemption process.
4. Ownership and Dividends:
- When investors buy shares of an ETF, they own a portion of the fund, not the underlying assets themselves.
- If the ETF’s underlying assets generate income (such as dividends from stocks or interest from bonds), this income is typically passed on to the ETF shareholders, either as cash pay-outs or reinvested in the fund.
5. Tracking Performance:
- Most ETFs are designed to track the performance of a specific index or sector. The fund's holdings are adjusted periodically to continue mirroring the index's performance as closely as possible.
6. Transparency and Management:
- ETFs usually disclose their holdings daily, allowing investors to see exactly what assets the ETF holds at any given time.
These are designed to track and replicate the performance of a specific market index, such as the Nifty 50 or Sensex. They invest in the same securities that make up the index in the same proportions.
Bond ETFs invest in a diversified portfolio of bonds, including government and corporate bonds. They offer regular income through interest payments and are suitable for investors seeking stable returns.
Commodity ETFs invest in physical commodities like gold, silver, oil, or agricultural products. They provide exposure to commodity prices without the need to buy physical goods.
Sectoral ETFs focus on specific economic sectors, such as technology, healthcare, or energy. They aim to provide exposure to the performance of companies within that sector.
International ETFs invest in foreign markets, offering global exposure to equities or bonds. They can include investments in specific countries or regions outside of India.
Thematic ETFs focus on specific investment themes or trends, such as environmental sustainability, innovation, or demographic shifts. They invest in companies aligned with these themes.
Understanding The Basics Of ETF Investing With Shradha Thakker
Kotak Securities
•06m 52s
ETF Investing Q&A With Shradha Thakker
05m 54s
Benefits of Investing in ETFs
Intraday Trading Flexibility
Unlike mutual funds, which are priced at the end of the trading day, ETFs can be bought and sold throughout the trading day at market prices, allowing investors to capitalise on intraday price movements.
Low Expense Ratios
Compared to traditional mutual funds, ETFs generally have lower expense ratios. This means you pay less management fees, making them a cost-effective option for long-term investing. ETFs use passive management to track a specific market index, requiring minimal adjustments and avoiding frequent trading. This results in lower administrative costs.
Liquidity
ETFs are traded on major stock exchanges, similar to individual stocks. This means you can buy and sell ETFs throughout the trading day at market prices. The ability to trade ETFs with ease adds flexibility to your investment strategy.
Transparency
ETFs provide transparency with their holdings. Most funds regularly disclose their assets, enabling investors to see precisely which securities are included in the ETF. This transparency helps you understand your investments and ensures you can make well-informed decisions.
Diversification
ETFs offer the risk diversification benefits of mutual funds by spreading investments across a wide range of assets. This reduces unsystematic risk, which is company or sector-specific, and ensures exposure to a broader market index.
Hedging and Arbitrage Opportunities
ETFs can be used to hedge risks, arbitrage between cash and futures markets, and implement covered option strategies, providing flexibility for both institutional and individual investors.
Better risk management
As passively managed funds, ETFs eliminate the risk associated with a fund manager’s decisions, ensuring that the investment mirrors the performance of the underlying index with minimal tracking error.
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FAQs
What are the benefits of ETF over traditional mutual fund schemes?
| Feature | ETFs | Securities | Traditional Mutual Fund |
|---|---|---|---|
Real-time trading and pricing during market hours | Yes | Yes | No |
Convenience of putting limit orders | Yes | Yes | No |
Ability to be traded real-time on the Stock Exchange | Yes | Yes | No |
Arbitrage between Futures and Cash Market | Yes | Yes | No |
Diversification possible with a single unit | Yes | No | Yes |
Returns in sync with the market/ benchmark index | Yes* | No | No |
Intra-day trading | Yes | Yes | No |
Exit Load | No | No | Yes |
*Returns are subject to Tracking Error
What is the cost involved in investing in ETFs?
While ETFs have a low expense ratio, they do have some charges that are specific to them. Because ETFs, like stocks, are purchased as shares through a broker, an investor must pay a brokerage commission each time he or she makes a purchase. In addition, an investor may incur the standard fees of stock trading, such as disparities in the ask-bid spread and so on. Traditional mutual fund investors, on the other hand, are indirectly susceptible to the same trading charges because the fund pays for them.
What are the risks associated with investing in ETFs?
ETFs have specific risks in spite of their diversification benefits. Generally, the risk associated with investing in ETFs are broadly classified into:
- Risk related to the Market: ETFs are exposed to market risks like stock and other mutual funds in spite of their diversification benefits. The broader the index that an ETF tracks, the lesser will be its’ market risk, but it can’t be completely eliminated.
- Liquidity risk: ETF liquidity has two components – first is the volume of ETF units traded on the exchange and the liquidity of the individual securities in the portfolio. The counter of ETF may tend to have a higher bid-ask spread in case of volatility in the market. Similarly, any security with insufficient liquidity in the portfolio of the index may also lead to inefficient tracking which in turn leads to differences in returns.
- Portfolio Risk: There are many kinds of ETFs available in the market including international and exotic ETFs. Hence, selecting the right ETF to meet investors’ needs is the key to avoiding risks associated with the portfolio. Portfolio risk could be additionally topped with Currency Risk, Counter-Party risk, Geo-Political risk, and sector-specific risks.
- Risk related to structure: ETFs can have different structures depending on what they invest in and how they distribute the capital gains from the portfolio. This can affect the tax liability of the investor. For example, ETFs using in-kind exchanges do not distribute capital gains to end investors while ETFs involving derivatives or commodities may have complex structures and tax implications. ETFs also face Tracking Error i.e. their return will deviate from the return of the underlying index because an ETF incurs certain expenses that the index doesn’t face.
How to invest in ETFs through Kotak Securities?
- Login to kotaksecurities.com
- Click on ETFs and select the ETF you want to invest in
- Place order and click on Buy/Sell
- It will redirect to the equity order placement page where you need to enter details like Price, Quantity, and some other details and submit order
How can I start investing in ETFs if I don’t have a demat account?
A demat account is essential for holding and trading ETFs in electronic form. You can open a demat account through a registered broker or a financial institution. Once your account is set up, you can begin investing in ETFs, just like you would with stocks, directly through your trading platform.
To open a Demat account with Kotak Securities, click here.
What are the key features of Exchange Traded Funds (ETFs) in India?
Exchange Traded Funds (ETFs) in India are investment funds that track specific indices like the Nifty 50 or Sensex. They are listed and traded on stock exchanges, allowing investors to buy and sell them throughout the trading day at market prices. They offer diversification by giving exposure to a broad range of securities within a single investment.
When is the NAV of an ETF updated?
The Net Asset Value (NAV) of an ETF is calculated at the end of each trading day. This NAV reflects the value of the underlying securities held by the ETF and is determined by dividing the total value of the ETF’s assets by the number of outstanding units. The end-of-day NAV accurately represents the ETF’s value and is used as the basis for transactions and reporting.
How do ETFs compare to actively managed Mutual Funds?
Here’s a concise comparison between ETFs and actively managed mutual funds:
| ETFs | Actively Managed Mutual Funds | |
|---|---|---|
Management Style | Passively tracks an index | Actively managed to outperform an index |
Trading | Trades throughout the day on exchanges | Trades at end-of-day NAV |
Fees | Generally lower | Generally higher |
Transparency | Holdings are disclosed daily | Holdings are disclosed less frequently |
Liquidity | High liquidity due to intraday trading | Lower liquidity, trades at NAV |
How do ETFs differ from Index Funds?
Here’s a concise comparison between ETFs and Index Funds:
Purchased and redeemed directly through the fund at the end of the trading day.
Priced once a day at the NAV (Net Asset Value).
No brokerage fees, but there may be entry/exit loads.
Less liquid, only traded at the end of the day.
Slightly higher expense ratios due to operational costs.
No, a demat account is not required for index funds.
| ETFs (Exchange-Traded Funds) | Index Funds |mobiel_header | |
|---|---|---|
Trading | Traded on stock exchanges like individual stocks. | Purchased and redeemed directly through the fund at the end of the trading day. |
Pricing | Prices fluctuate throughout the trading day. | Priced once a day at the NAV (Net Asset Value). |
Transaction Costs | Brokerage fees apply for each buy/sell transaction. | No brokerage fees, but there may be entry/exit loads. |
Liquidity | Generally more liquid, can be bought or sold anytime during market hours. | Less liquid, only traded at the end of the day. |
Expense Ratio | Generally lower expense ratios compared to index funds. | Slightly higher expense ratios due to operational costs. |
Demat Account Requirement | Yes, a demat account is required to trade ETFs. | No, a demat account is not required for index funds. |
How do ETFs differ from Futures & Options (F&O)?
Here’s a concise comparison between ETFs and F&O:
| Aspect | ETFs (Exchange-Traded Funds) | Futures & Options (F&O) |
|---|---|---|
Nature of Investment | ETFs represent a basket of securities, usually tracking an index. | F&O are derivative contracts based on an underlying asset. |
Ownership | Investors own the underlying assets (stocks, bonds, etc.). | No ownership of the underlying asset, only the right/obligation to buy/sell. |
Pricing | Prices fluctuate throughout the trading day based on market supply and demand. | Prices depend on the underlying asset and time of expiration. |
Risk Level | Generally considered lower risk, suitable for long-term investment. | Higher risk due to leverage and potential for unlimited loss (in futures). |
Leverage | No leverage; investors pay the full price of the ETF. | High leverage; only a margin is required to control a large position. |
Expiry | No expiry; ETFs can be held indefinitely. | Contracts have a specific expiry date (monthly/quarterly). |