What are ETFs?
ETFs are funds that invest in an index or commodity or group of stocks or bonds similar to mutual funds. However, unlike mutual funds these are listed on the exchange and are not managed by fund managers.
Let us see an example. In case you think economy is doing well, you would like to invest in Nifty index. You can choose a few good stocks and invest. However, it is not ideal to buy all the 50 stocks listed under “Nifty”. To earn the return on nifty without investing in each stock included in the index you can invest in an ETF which replicates the return on that index.
- Bond ETFs might include government bonds, corporate bonds, and state and local bonds—called municipal bonds.
- Industry ETFs track a particular industry such as technology, banking, or the oil and gas sector.
- Commodity ETFs invest in commodities including crude oil or gold.
- Currency ETFs invest in foreign currencies such as the Euro or Canadian dollar.
- Inverse ETFs attempt to earn gains from stock declines by shorting stocks. Shorting is selling a stock, expecting a decline in value, and repurchasing it at a lower price.
How do they trade?
Since the ETFs are listed on an exchange, they trade throughout the day like ordinary stock and can be held on a Dmat account, while mutual funds are valued at the end of the day with NAV (Net Asset Value) and not all mutual funds are in dematerialized form (i.e. needs to be held physically).
Now, this is an important point. ETFs are passively managed. Nifty BeES shown above is replicating the performance of Nifty therefore there is no need of a fund manager to manage the fund which brings the cost down. However, a mutual fund is actively managed by a fund manager who decides where the money should be invested, there is a cost associated to run such funds which is embedded in fees which the customer has to bear. This cost/fee is called expense ratio which is expressed in percentage. It is that part of your investment that the fund takes each year to compensate and meet with expenses for managing your money.
The average expense ratio for actively managed traditional mutual funds is 1.09, according to Morningstar. For index funds, it’s 0.79 percent. For ETFs, meanwhile, the passive bulk of them come with an expense ratio of 0.57 percent. The actively managed ones, 0.76 percent. Check out how much a 2% fee costs when your investment grows over a period of time. It is simple calculation without compounding.
|Funds||Expense Ratio||Cost per Lakh||Cost per Crore||Cost per 10 Crore|
|ETF (passively managed)||0.50%||500||50,000||500,000|
|ETF (actively managed)||0.70%||700||70,000||700,000|
Best way to explain this is…… since the expense ratio is charged on a regular basis, a high expense ratio over the long term may significantly eat into your returns as a result of the power of compounding. For example, Rs 1 lakh over 10 years at the rate of 15 per cent will grow to Rs 4.05 lakh. But if we consider an expense ratio of 1.5 per cent, your actual total returns would be Rs 3.55 lakh, nearly 14 per cent less than what it would have been without any expense charge.
Initially a 2% fee would not look very big on an investment of Rs. 10,000. However if you intend to hold the investments until retirement and expect your corpus to grow over crores then the fee that gets paid would be a pinch. It would be too late after 20 years to change anything. (Hmm, no wonder there are no advertisements to invest in ETFs isn’t it!)
Mutual Fund NAVs (net asset values) are reported net of fees and expenses. So if you want to know how much the fund is deducting, the expense ratio can be found under the ‘Disclosures’ tab on the website of the given asset management company (AMC).
Liquidity means how quickly can you get your cash if you decide to sell your investments. Liquidity is an issue in most of the funds including mutual funds. Be careful and check before investing.
Return on Investment (ROI)?
The most important parameter for choosing the investment is the return. Over a long period of time equity is what beats inflation. You can use gold as hedge to offset partial loss on equity investments. ETFs can be seen as a vehicle for diversification and hedging. Also, for those who do not want to take responsibility of choosing stocks or depending on someone for investments the easiest way to invest is through ETFs. Last one year’s return on Indian ETFs are shown below. When equity gave 6% return gold gave 29%…well not bad at all. Gold ETFs are easy to manage as compared to physical gold. Apart from losing the quality and worth, it needs to be safeguarded. Unless it is put into use gold will sit in your locker for years and years.
Good to know:
There are other varieties of ETFs in the world which are not really a retail investor’s interest. It is worth knowing anyway.
Real-World Examples of ETFs
Below are examples of popular ETFs on the market today. Some ETFs track an index of stocks creating a broad portfolio while others target specific industries.
- SPDR S&P 500 (SPY): The oldest surviving and most widely known ETF tracks the S&P 500 Index
- iShares Russell 2000 (IWM): Tracks the Russell 2000 small-cap index
- Invesco QQQ (QQQ): Indexes the Nasdaq 100, which typically contains technology stocks
- SPDR Dow Jones Industrial Average (DIA): Represents the 30 stocks of the Dow Jones Industrial Average
- Sector ETFs: Track individual industries such as oil (OIH), energy (XLE), financial services (XLF), REITs (IYR), Biotech (BBH)
- Commodity ETFs: Represent commodity markets including crude oil (USO) and natural gas (UNG)
- Physically-Backed ETFs: The SPDR Gold Shares (GLD) and iShares Silver Trust (SLV) hold physical gold and silver bullion in the fund.
Note: Some information could be from other research sources available on google.