ETF’s are basically close ended index mutual funds, whose shares can be traded in stock market like shares of companies (intra-day trading is also possible).
Like index funds, ETF’s also simply mimic their underlying index. How they do it? ETF’s buy all securities in the “same proportion” as that of its underlying index.
Nifty 50 can be one underlying index. Nifty 50 index has 50 stocks as its constituents. Not all 50 stocks has same weightage in the index.
Example, in Nifty 50 index the weightage of its top 10 stocks (as on 30-Nov’19) is as shown below:
To mimic Nifty 50 Index, the ETF portfolio must be composed of all 50 stocks in the same weightage (proportion).
Index mutual funds also build their portfolio like this, but units of mutual funds are not traded live in stock market. But shares of ETF’s are traded live.
An ETF is simply a Mutual fund which is close ended, listed on the exchanges and tracks an Index of any asset.
INDIRECT INVESTING IN EQUITY
So, ETF is indirect investing in stocks. And how does ETF help? Well, by investing in ETF the investor need not decide which stocks to buy, and when to sell. Means, the step of stock analysis can be totally avoided by the investor. This part is taken care by the mutual fund manager.
Investors just need to contribute their money, the fund manager will do the rest. The fund manager will invest the pooled money (wisely), with the objective of good returns for the future.
ETF AND ‘REAL TIME PRICING’
Further, while dealing ETF’s, one gets an advantage of ‘real time pricing‘, but while investing in mutual funds one is always allotted the NAV based on the market closing rate. Market price of ETF’s change in real time (like stocks).
What is the benefit of real time pricing?
If prices change in real time, one can capture best prices for the day through ETF or take advantage of temporary intra-day lows. Example, lets say the market has corrected by 2% at 11 a.m. on a particular day and one has bought an index ETF 2% down, now by market closing time at 3.30 p.m market recovered and closed 1% up, then if you had invested in an Index mutual fund you will be allotted an NAV the next day at 1% higher value than previous close but with index ETF you were able to capture the intra-day low of 2% and made a 2% extra return in one day itself through the advantage of real time pricing of the ETF.
This flexibility of buying/selling at ones will, makes ETFs a unique investment vehicle. But mutual funds does not have this advantage.
PASSIVE INVESTING AND ETFs
Building right frame of mind for investing is critical. What is the right frame of mind? Practicing passive investing. What is passive investing? No active involvement. Just buy an investment, and forget about it.
ETF in India is one good example of passive investing. Below are the characteristics of ETFs which makes it suitable for passive investing.
- No Active Management: The best part of ETF is, there is no active fund manager who is taking decisions on which stocks to buy and sell. How this is a best part? Because here the decision maker is one who is in some ways wiser than the traditional ‘fund managers’. Who is the decision maker? The decision maker is Mr. Market.
- Less Risky than Stocks: Chances of a loss when one is investing in a single stocks is high. But as portfolio of ETF consists of several stocks, it gives the advantage of diversification. Hence ETFs are less risky than direct stocks.
- Buy Best Stocks at low cost: Suppose you want to buy best blue chip stocks. Do you know what is the best way to do it? Buy a Nifty or Sensex based index ETF. Another example, if you want to buy stocks of best banks, buy a Bank ETF.
- Very Long Term Holding: There is risk involved when a person is holding stocks for very long term. Why? Because the business fundamentals of individual stocks may go down with time. But business fundamentals of an index (Nifty), will remain intact always. How? Because index necessarily includes only the best stocks.
- Lowest Cost: As there is no active fund management involved, ETFs are most cost effective for investors (even compared to index funds).
HOW TO SELECT A GOOD ETF ?
So now we know what are ETF’s and its advantages over traditional stocks and mutual funds. But how to pick a good ETF? Which are the parameters one must look in a mutual fund before buying its shares?
Preferred Benchmark: There are mainly 4 types of ETFs available in India. Equity based, debt based, gold and world indices based. Inside equity based ETFs we have ETFs which track main indices, banks, mid cap stocks, infrastructure stocks etc. So before one buys an ETF, he/she must select the preferred theme. See the list of all ETF here.
High Trading Volume: Investors must take care to buy an ETF whose trading volume is high. Why? Because for traders, low trading volume will result in higher bid-ask spread, leading to more cost of investment. Example: trading volume of ‘Nippon India ETF Nifty BeES’ as on 17-Dec’19 was Rs.592.12 Lakhs. Similarly, trading volume of ‘Axis Nifty ETF’ as on 17-Dec’19 was just Rs.1.17 Lakhs. So what do you think, which ETF will be better? Nippon India ETF Nifty BeES will be better.
Low Tracking Error: The difference between returns generated by ETF and Nifty’s appreciation is called tracking error. Investor must pick the ETF with minimum tracking error. For example in the last six months Nifty has appreciated by 2.72%. In the same period, the NiftyBeES has appreciated by 2.73%. The tracking error is only 0.01%.
Low Expense Ratio: As ETF’s track an index, hence they are not actively managed. This substantially brings down their expense ratio. A typical Nifty 50 ETF will have an expense ratio as low as 0.55%. But Nippon India ETF Niftybees has declared its expense ratio as 0.05% as on 30-Nov’19. Read more about expense ratio of mutual funds.
TYPES OF ETF’S IN INDIA
ETFs which operate in India can be classified into the following 3 broad categories.
World Indices (like NASDAQ 100 & HangSeng)
There are about 75 ETFs listed and traded in India. See the list here. The total asset size (AUM) of all these ETFs is close to Rs.147,187 Crores as of September 2019.
COMPARISON BETWEEN INDEX FUNDS, ETF’S, AND STOCKS
Why an investor should care to know about the difference between index funds, ETF and stocks? Because it will help one to pick the best alternative.
So which is the best alternative between these three options?
Novice but passionate about stocks: This is that investor who is so passionate about trading stocks that, for him/her nothing else works. But the person lacks the expertise of stock analysis. This type of investor can go with Index ETF
Interested in equity (but can do only passively): Who are these investors? These are people who are busy. They cannot actively manage their investment portfolio. They neither have time to learn stock analysis. But they would like to take advantage of equity investing (in terms of high returns). This type of investor can go with index ETF..
Knows Stock Analysis: Who are these people? These are people who have figured out how to analyze stocks. Hence they have a knack to pick stocks. Such type of investors should go with direct stock investing. People who know how to handle stocks, can generate much higher returns than ETFs and Index Funds. Cost Sensitive Investor: You can see the above table. ETF’s are the most cost effective investment option among mutual funds. At Tradeplus we offer zero brokerage for stocks and ETF which makes investment in stocks and ETF through us the lowest in India. In long term, lower cost of ETF can ensure higher returns than index funds. Both ETF and Index Funds track an index. Hence they can yield only averaged returns. But as ETF has a lower cost, it will generate better returns than index funds in long term.