WHAT IS AN ETF?
An ETF is fundamentally an Index Fund (a fund which replicates a market index) traded in the market like a stock.
ETFs are different from the mutual funds in the way the market price is calculated and the way they are traded. In the case of a mutual fund the NAV is calculated daily at the end of the day once but in the case of an ETF, the market price changes real time with the underlying asset prices. This is achieved through arbitrage mechanism which keeps the market price of the ETF tentatively in line with the NAV of the underlying securities. The arbitrage mechanism to work, ETFs are required to maintain a full disclosure of fund’s holdings. As mutual fund NAVs are calculated at the end of the day, intraday trading is either impossible or very expensive. Whereas ETFs can be traded intraday like a stock.
FEATURES OF ETFs
1. Creation and Redemption
the Asset Management Company sponsoring the ETF takes securities (comprising the index) and “Cash Component” from various investors such as institutions and large investors. These investors, in turn, receive large blocks of ETF units called “Creation Units”. These investors can hold these “Creation Units” in their portfolios or break them up to sell them on the exchange. A retail investor cannot buy ETF unit directly from an Asset Management Company.
The institutional investors, in turn, can redeem the ETF units for the underlying shares.
2. Number of outstanding units
The number of outstanding units of an ETF is not fixed. The number of units may increase as the institutional investors deposit shares to create ETF units or redeem ETF units for shares.
As mentioned above, ETF units are traded in the exchange whole day at real-time NAV. The above-mentioned creation and redemption method of ETF units ensure that ETFs market price reflects the NAV of the underlying fund. Any deviation is expected to be arbitraged away.
As ETF units are traded real time in the exchange, intraday trading is possible. Also, short-selling of ETF units is possible.
ADVANTAGES OF AN ETF
1. Inexpensive diversification
ETFs provide diversification as they replicate some benchmark index (generally). As there is no active fund management required, the expense ratio for an ETF is much lower than an equity mutual fund.
As ETF units are traded in the exchange at real-time NAV, ETFs provide much higher liquidity compared to a mutual fund.
3. Shorting and Hedging
As ETFs units can be used for short-selling, many trading strategies can be implemented using ETFs.
Short selling of ETF units can also be used to hedge against a decline in the overall market or a specific sector.
4. Portfolio Transparency
ETF portfolios are disclosed daily compared to periodic disclosure of the mutual funds.
5. Margin Trading
Margin trading is possible in ETFs allowing investors to take larger exposures.
MAJOR TYPES OF ETFs
Although equity Index ETFs are the most common type of ETFs, there are various other kinds of ETFs.
1. Index ETF:
Replicates an equity index such as Nifty 50 or Sensex 30.
2. Equity ETF
Exposrue to a pool of equities in a particular sector or index.
3. Commodity ETF:
Invests in commodities such as Gold and Silver and tracks the commodity price.
4. Debt ETF:
ETFs which allow investors to get exposure in fixed income securities. These ETFs replicate the returns from bond indexes.
4. Global ETFs:
Allows domestic investors to take exposure to the international indices.