What are Exchange Traded Funds (ETFs) and how do they work?

22 December 2021
4 mins read
What are Exchange Traded Funds (ETFs)  and how do they work?

The mutual fund industry introduced 18 exchange-traded funds (ETFs) this year, ranging from those that invest overseas to those that follow factor-based investing, as well as those that invest in sectors or themes. However, many investors wonder if they should invest in an ETF or an index fund.

What distinguishes ETFs from index funds?

Index funds and exchange-traded funds (ETFs) are both passive funds. Both funds have no intention of outperforming or underperforming their respective benchmark indexes. An ETF, like an index fund, selects a benchmark index and then attempts to replicate the index’s performance. That’s the extent of the distinction.

Only the stock exchange offers ETFs, which you may purchase and sell during market hours. Index funds try to replicate the performance of an underlying index. Investors, on the other hand, are not offered intraday purchasing or selling prices. The net asset values (NAVs) of the funds are announced at the end of each day. According to the Securities and Exchange Board of India’s new laws, an investor may only acquire that day’s NAV when her contribution is credited to the fund. Depending on the manner and duration of your investment, this might take a few days or even longer. ETFs, on the other hand, are traded like stocks, which means that investors may buy or sell the ETF at the current market price.

Why do ETF tracking mistakes tend to be fewer than index fund tracking faults?

The structure of an ETF is seen to be superior to that of an index fund. An index fund functions similarly to a traditional mutual fund. When investors participate in the fund, the fund purchases the underlying securities in such a manner that the portfolio closely mimics the underlying index. In the fund, the fund manager has some cash. The higher the cash component, the more the scheme’s performance deviates from its benchmark. Despite the index fund manager’s best efforts to limit the cash component to a bare minimum, money does not always be deployed immediately. A tracking error arises as a result of this.

In contrast, an ETF unit is only established by swapping a basket of assets with the fund house. A unit basket’s elements are set in stone and cannot be modified; generally, underlying securities plus a small amount of cash. This keeps the cash component of an ETF in control, resulting in decreased tracking error. Large investors may, of course, swap their stock basket directly with the fund company, but they must have the basket precisely as stipulated.

Who generates ETF liquidity on the stock exchange?

Market makers play a significant part in the life cycle of an ETF here. To provide liquidity on the stock exchanges, fund firms designate market makers for each of their ETFs. Individual brokers generate (and destroy) units directly with the fund house so that regular investors may buy and sell them on the exchange easily and anytime they wish.

Intraday NAVs (iNAVs) is also published by ETFs, which are updated by MFs during the trading session. The iNAV is the ETF’s current value, calculated from the value of the index’s holdings.

Is it possible to immediately sell all of our index funds and convert them to ETFs?

That’s not the case. An exchange-traded fund (ETF) may be more expensive than an index fund. Because ETFs may only be purchased and sold on stock exchanges, you’ll need a demat account. Brokerage fees are also charged; most charge up to 0.5 percent every transaction. Discount brokers don’t impose fees if you take delivery of an ETF.

ETFs with low market volumes lack liquidity since you may not be able to find enough buyers to sell your shares or enough sellers to acquire certain units, resulting in impact costs for investors. The impact cost is the difference between the price you actually pay and the scheme’s NAV.

How do you evaluate the performance of an exchange-traded fund (ETF)?

The tracking errors or variances in performance from their respective benchmark indexes are the best indicators of passive funds’ success. Tracking mistakes of passive funds, particularly index funds, have decreased over time as fund companies and markets have matured.

However, there are additional reasons for tracking inaccuracies. Stock prices may be erratic when the underlying elements of an index fluctuate. On days like this, it’s also tough to replicate the index. Lack of liquidity in the underlying index’s stocks contributes to tracking inaccuracy by causing high impact costs when buying and selling. As a result, the tracking error of a small-cap and mid-cap passive fund is often larger than that of a large-cap fund.

Disclaimer: This blog is exclusively for educational purposes and does not provide any advice/tips on investment or recommend buying and selling any stock.