How ETFs work and their types

Exchange Traded Funds, or ETFs, and index funds are passive instruments.

An index fund is a type of mutual fund whose holdings match or track a particular market index. Same with an ETF, which is designed to track a particular index.

When it comes to an index fund, the Net Asset Value, or NAV, is declared at the end of the day and investors can buy and sell units at this price.

The difference is that an ETF is listed on a stock exchange, just like shares. And are traded on a real-time basis. A major plus point of ETF is that you can take advantage of real-time price which could help you to book profit instantaneously in an intra-day high NAV. A real-time NAV is particularly beneficial during times of high market volatility, subject to the availability of liquidity. This advantage is missing in index funds where you can trade only at NAV declared at end of day.

Index funds come with regular and direct plans. You can buy an index fund from your distributor or adviser, and you do not need a demat account. But you do need the latter when buying an ETF. Since it is listed on the stock exchange, a demat account is mandatory.

Investors should factor in that they incur trading costs while transacting in ETFs.

ETFs are created by large money managers who bundle the underlying instruments of the fund together. It is offered for sale to the public and can be purchased through a broker. The ETFs track indexes for stocks (domestic and international), bonds, commodities, gold and currencies. One can buy ETF on margin, short sell, or hold for the long term.

A major advantage of both index funds and ETFs is their simplicity, low cost and diversification. Do note that index funds can charge a slightly higher expense ratio as compared to ETFs.

Types of funds

Investors have different options under ETFs/index funds, depending on where the product invests and the strategy. Here are some broad categories:

Sector based

Some fund houses offer sector-based ETFs funds that track sectoral indices such as banking, PSU Bank, private bank, infrastructure and information technology indexes. The risk involved in such sectoral ETFs funds is higher than other diversified passive funds because the entire portfolio exposure is concentrated in that single sector. One sector/theme may not perform every year as winners often rotate depending on the economic cycle, as is evident from the historical performance of such funds. So one would do well to steer clear of such ETFs, unless one is seeking a tactical exposure based on a strong view on the sector. The risk of investing in a sector ETF is aggravated vis-à-vis investing in an actively managed sectoral fund since ETFs are designed to hold the underlying stocks as per the weightage in the index at all times. 

Market cap weighted funds

Such ETFs/index funds invest in stocks in the same proportion as their weightage in the benchmark index. For instance, let’s consider an index fund tracking the Nifty 50 index. HDFC Bank has the highest weightage in the Nifty 50 index at 11.21%. The market cap weighted index fund tracking Nifty 50 will try to hold approximately the same weightage (11%) of its net assets in HDFC Bank. One disadvantage of this strategy is that investors could be exposed to stocks that are overvalued, due to which a few stocks becomes a large portion of the index. Unlike active funds where fund managers decide the weightage of stocks based on their view, index funds and ETFs follow a rule-based investment methodology. This eliminates human bias.

Equal weighted funds

Equal weighted index funds try to hold a fixed percentage of the fund’s assets, say 2% each in the underlying index at all times. So an equal-weighted index fund will hold 2% in the above-cited example even if HDFC Bank’s weightage in the underlying index is more than 11%. This ensures that investors have an equal amount of diversification to all 50 stocks in the index. In the same vein, an equal-weighted index fund will hold 2% in Tech Mahindra, whose weightage in the Nifty 50 is 0.97%. 

Debt ETFs 

As the name suggests, debt ETFs give exposure to investors to the fixed income market. In India, investors have limited options that include Liquid ETFs, PSU Debt ETFs, government securities or gilt ETFs. Gilt ETFs are a safer option for investors as they do not carry any credit risk. However, the returns from gilt securities are susceptible to interest rate changes.

The government of India has started utilising debt ETFs as a way to attract a larger number of investors. The Debt ETF market is still in its nascency with limited issuers and lack of liquidity. 

Gold ETFs 

Gold ETFs aim to mimic the domestic spot price of gold as closely as possible. Asset managers create units of the scheme which are listed on stock exchanges. These units are backed by physical gold and are held in custodian accounts. Each unit of the scheme is typically equal to 1 gram of gold, depending on the ETF. Gold ETFs are a convenient and low- cost way of taking exposure to gold prices. 

Smart beta

Fund houses offer smart beta ETFs which follow a rule-based investing approach. Such funds apply certain factors like dividend yield, momentum, quality, low volatility, and so on while selecting stocks. Such ETFs can be thought of as a hybrid between passive and active investing, along with the benefit of low-cost investing. Investors can choose a fund that offers a portfolio that filters securities based on a combination of factors, rather than the conventional market-cap weighted index fund/ETF.

To sum up, choose a fund that best suits your goals and investment horizon by consulting your financial adviser.

Source: Morningstar India Website