What is an Exchange-Traded Fund (ETF)?

What is an Exchange-Traded Fund (ETF)?

An exchange-traded fund (ETF) is a type of pooled investment security that operates much like a mutual fund. Typically, ETFs will track a particular index, sector, commodity, or other assets, but unlike mutual funds, ETFs can be purchased or sold on a stock exchange the same way that a regular stock can.

An ETF can be structured to track anything from the price of an individual commodity to a large and diverse collection of securities. ETFs can even be structured to track specific investment strategies.

The first ETF was the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index, and which remains an actively traded ETF today.

Types of exchange-traded fund

  • Index ETF: Designed to track a particular index like the S&P 500 or NASDAQ
  • Fixed Income ETF: Designed to provide exposure to virtually every type of bond available; US Treasury, corporate, municipal, international, high-yield and several more
  • Sector and industry ETF: Designed to provide exposure to a particular industry, such as oil, pharmaceuticals, or high technology
  • Commodity ETF: Designed to track the price of a commodity, such as gold, oil, or corn
  • Style ETF: Designed to track an investment style or market capitalization focus, such as large-cap value or small-cap growth
  • Foreign market ETF: Designed to track non-US markets, such as Japan’s Nikkei Index or Hong Kong’s Hang Seng index
  • Inverse ETF: Designed to profit from a decline in the underlying market or index
  • Leveraged ETF: Designed to use leverage to amplify returns
  • Actively managed ETF: Designed to outperform an index, unlike most ETFs, which are designed to track an index
  • Exchange-traded note (ETN): In essence, debt securities backed by the creditworthiness of the issuing bank, which were created to provide access to illiquid markets; they have the added benefit of generating virtually no short-term capital gains taxes
  • Alternative investment ETF: Innovative structures, such as ETFs that allow investors to trade volatility or gain exposure to a particular investment strategy, such as currency carry or covered call writing
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Who are the Authorized Participants in an exchange-traded fund ?

A unique feature of an Exchange-Traded Fund is that it has Authozied Participants who help facilitate the market for fund units.

As per regulatory directives, Authorized Participants (APs) are designated to create and redeem ETFs. APs are large financial institutions that have huge buying power and market makers, such as large broker-dealers and investment banks and companies.

In creating the fund, APs assemble the required portfolio of asset components and turn the basket over to the fund in exchange for a number of newly created ETF shares.

When the need for redemption arises, APs return the ETF shares to the fund and receive the portfolio basket.  Individual investors can participate by using a retail broker who trades in the secondary market.

Why invest in exchange-traded fund?

ETF may be a better choice

There are a number of factors that play a crucial role in determining future performance of a mutual fund scheme, for example – fund manager’s track record, AMC track record, long term performance etc. It takes considerable skills to identify a good fund that may outperform its peers and also the market in the future.

Exchange Traded Funds, on the other hand, tracks only the Index that it is benchmarking and therefore, there is little scope of outperformance or underperformance. If you aim for market/ Index returns for your investment, the ETFs may be a good choice.

Performance is the focus

The indices, which by their method of construction based on market capitalization, eliminate or at least, reduce the weight of underperformers in the index portfolio. Therefore, by extension ETFs also eliminate or at least reduce the weight of underperformers in their portfolio.

Unsystematic Risk

Mutual funds are subject to two kinds of risk – Systematic and Unsystematic risks. Systematic risk is unavoidable because equities as an asset class are volatile. Both ETFs and actively managed funds are subject to market risks.

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 Unsystematic risk is company specific risk or sector specific risk. Though mutual funds aim to reduce unsystematic risk by diversifying its portfolio across stocks and sectors, they still have some residual unsystematic risks because actively managed funds may be over-weight on certain stocks and sectors versus the index.

Exchange Traded Funds do not have any unsystematic risk because they simply track the index; therefore, it is a good investment option if you want to totally avoid unsystematic risk.

Low cost

The expense ratio of ETFs is much lower than their mutual fund counterparts. The expense ratios of ETFs can be as low as 0.25%, compared to the expense ratio of mutual funds which are usually in the range of 1.5% – 2.25%. Unless the mutual funds generates considerable alpha in the long term, they may not be able to beat the ETF returns in the long term.

Simplicity

ETFs bring simplicity to your investing compared to actively managed funds. You do not have to analyze past performance or understand the fund manager’s investment style or how the fund has done in up and down markets etc.

Most ETFs track the large cap indices like Nifty, Sensex, BSE – 100, Nifty 100, Nifty Next 50 etc. You can simply select an index and invest in a low cost ETF, which tracks that index and your job is done.

Advantages of exchange-traded fund

  • Easy to trade – You can buy and sell any time of the day, unlike most mutual funds that trade at the end of the day
  • Transparency – Most ETFs are required to publish their holdings daily
  • More tax efficient – ETFs typically generate a lower level of capital gain distributions relative to actively managed mutual funds
  • Trading transactions – Because they are traded like stocks, investors can place a variety of order types (e.g., limit orders or stop-loss orders) that can’t be made with mutual funds
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Disadvantages of exchange-traded fund

However, ETFs do have drawbacks, including:

  • Trading costs: If you invest small amounts frequently, there may be lower-cost alternatives investing directly with a fund company in a no-load fund
  • Illiquidity: Some thinly traded ETFs have wide bid/ask spreads, which means you’ll be buying at the high price of the spread and selling at the low price of the spread
  • Tracking error: While ETFs generally track their underlying index fairly well, technical issues can create discrepancies
  • Settlement dates: ETF sales are not settled for 2 days following a transaction; that means as the seller, your funds from an ETF sale aren’t technically available to reinvest for 2 days.

Example Exchange-Traded Fund Creation

  • Price of ETF trading on the exchange: $32.15
  • Fair Market Value of the ETF based on its underlying securities: $32.00

If this is the case, an Authorized Participant (AP) will want to buy the creation basket (the underlying stocks) and will pay $32.00 and exchange it with the ETF manager for a part of the creation unit. The AP now has shares of the ETF that it can sell in the market at the market price of $32.15 and profit $0.15 per share.

In turn, this process exerts downward pressure on the price of the ETF and upward pressure on the price of the underlying stocks, until no further arbitrage can be made. For illustrative purposes, this example doesn’t account for AP costs such as trading and fees, as well as hedging costs for cases in which blocks are demanded partially.

Conclusion

Because of the versatility, liquidity, and low trading costs that ETFs offer, they are an increasingly popular investment vehicle. Investors are urged to explore the large, varied offerings of ETFs, and to consider making ETF investments a mainstay of their overall investment portfolio.