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The world of ETFs – explained in simple terms

ETFs are an easy way to invest smartly in the stock market - don't miss out!

What are ETFs, and how do they work?

In 2001, Nippon India Mutual Fund, previously known as Reliance Mutual Fund, launched the first ETF in India. The Nifty 50 ETF, popularly known as “NiftyBees,” was the first of its kind and provided approximately 16% returns since its inception.

Two decades after the first one, over 150  ETFs are now listed on the NSE. Investors have various ETF options to choose from, including those that invest overseas, follow factor-based investment strategies, invest in specific sectors or themes, and more.

So, let’s understand what they are and how they work.

What is an ETF?

An ETF, or exchange-traded fund, is a unique investment vehicle combining diversification benefits of mutual funds with the simplicity of trading equities. ETFs are a type of investment fund that is traded on stock exchanges. Similar to mutual funds, ETFs pool money from multiple investors to purchase a basket of stocks, bonds, or other securities. 

However, unlike mutual funds, they are traded like individual stocks and can be bought and sold throughout the day at market prices.

They generally have lower fees and are more easily traded than other types of funds, making them a popular choice for many investors.

Plus, they are super diverse. They can hold all kinds of investments, from stocks and bonds to commodities and real estate. So whether you’re interested in technology, energy, or something else entirely, there’s probably an ETF out there for you.

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Let’s understand with an example: You think India’s technology sector will boom, but you don’t have the time or expertise to pick individual tech stocks. Instead, you could buy shares of an ETF that focuses on the Indian technology sector.

And the best part? You can buy and sell ETFs just like you would a regular stock. This makes them super easy to trade. So if you’re looking to invest in the stock market, but don’t want to bet on any one company or industry, consider checking out them.

How do ETFs work?

What makes them different from other investment funds is that they are designed to track specific indexes like the NIFTY 50 or SENSEX. They provide a number of advantages, including low cost, diversification, and liquidity.

The key difference between ETFs and a variety of funds is that they attempt to be the market rather than beat it. They simply replicate the performance of the Index they track.

Mechanics of ETFs

They are structured as open-ended mutual funds but trade like stocks. They are created and redeemed through a unique process that involves authorised participants (APs) and market makers.

Creation and redemption process

  • APs create new ETF shares by buying a basket of stocks that represent the underlying index.
  • The APs then transfer the basket of stocks to the ETF issuer in exchange for ETF shares.
  • The ETF shares are then sold to investors on the stock exchange. When investors buy shares of an ETF on the exchange, they’re buying shares that represent a slice of the underlying basket held by the fund.

Role of Authorised Participants

Authorised participants are entities that have the authority to create and redeem ETF shares. They are typically large financial institutions or market makers that work with ETF issuers to keep the ETF price in line with its underlying net asset value (NAV).
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Benefits of investing in ETFs

Flexibility of ETFs

ETF shares also trade exactly like stocks, allowing for greater flexibility in buying, selling, or holding positions. They are priced and traded continuously throughout the trading hours, and they can be bought on margin, sold short, or held for the long term, exactly like common stock. 

Passive Management

It is the chief distinguishing feature of ETFs, which means the fund manager makes only minor, periodic adjustments to keep the fund in line with its index.

Passive management mitigates the element of “managerial risk” that can make choosing the right fund difficult. When you buy shares of an ETF, you are harnessing the power of the market itself, as opposed to investing in an ‘active’ fund managed by a fund manager. 

Cost-Efficiency

They have lower administrative costs than actively managed portfolios since they track an index rather than attempting to outperform it. 

Typical ETF administration costs are lower than those of an actively managed fund, coming in at less than 0.20% per year, compared to more than 1% for certain actively managed mutual fund schemes.

Risks of Investing in ETFs

While they have many advantages, they also have some drawbacks to consider. Just like a coin, there are two sides to the story. Let’s take a closer look at these potential downsides.

Illiquidity

Some ETFs may have low trading volumes, making buying or selling shares at a fair price difficult. This can lead to significant bid-ask spreads, which can erode your returns over time.

Tracking Error

ETFs often mirror their underlying index closely. However, technical difficulties or market events might cause variances. These variations can cause significant differences between an ETF’s performance and its benchmark.

Types of ETFs and how each works

They are designed to cater to specific investment focuses, and some of the most popular ones are:

Active Equity ETFs 

Active Equity ETFs allow managers to use their judgment when purchasing investments instead of solely focusing on a benchmark index. Although they may outperform the market benchmark, they come with higher risks and greater costs associated with them.

Diversified Passive Equity ETFs 

Diversified Passive Equity ETFs tend to perform in accordance with popular stock market benchmarks like NSE, NIFTY 50 and BSE Sensex.

Fixed-Income ETFs 

Fixed-Income ETFs focus on bonds instead of stocks. They are actively managed, have lower trading frequency, and are typically more stable.

Commodity ETFs 

Commodity ETFs are designed to track the price of a specific commodity, like gold, oil, etc.

In conclusion, ETFs are a good investment option for those who want to invest in entire markets, sectors, regions, or asset types without the need for active management. 

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