Exchange Traded Fund (ETF): Meaning, Benefit and Factors To Consider

If you are interested in long-term investing, you might have encountered the term “ETF”. It stands for Exchange-traded funds (ETFs) which represent a basket of securities that trades just like an individual company's stock. 

The first ETF was launched in India in 2001, but it was not until 2015 that ETFs started gaining traction. The journey to listing the 100th ETF on NSE took more than 19 years. 

Generally, an ETF tracks an index, such as the Nifty or the Sensex. ETFs are passively managed and thus are cost-efficient compared to actively managed funds. Investors who buy ETFs should know that the returns on these funds will resemble the underlying index. Therefore, ETFs share the features of a stock and a fund. However, what factors you should consider while investing in ETFs? Let’s understand this.

Factors To Consider for ETF Investing

• Underlying index

Since all ETFs track an index, you must choose one based on your risk tolerance. For instance, the Sensex or Nifty ETF will track the Sensex or Nifty index, which constitutes the biggest companies in India that are considered stable. If you wish to invest beyond broad market indices, ample options are available. You can choose from various ETFs, including Next 50 ETFs, sectoral ETFs, momentum ETFs, quality ETFs, etc. Thus, next time choosing an ETF, select the market index that matches your risk tolerance and investment objective, find an ETF based on that index and invest accordingly. 

• Tracking error

As studied in the risk chapter, tracking error is the standard deviation of the difference between the daily total returns of the index and the net asset value (NAV) of the fund. Simply, it is the difference between returns from the index and an ETF. Generally, the lower the tracking error, the better the ETF's performance. Low tracking error means the ETF successfully replicates a benchmark, thus mirroring its returns more precisely and accurately. 

• Expenses

Investors select ETFs because they mimic the performance of the underlying benchmark index. As these funds are passively managed, they can do so at a minimal cost compared to an active equity fund. High expenses can impact the returns that you will earn over the longer term. Thus, if the funds' returns are similar to the index they track, you should choose the cheapest ETF. This will help you invest in your target index at a low cost without compromising on long-term returns. 

• Liquidity

Did you know one interesting data point about ETF? As per the data compiled up to March 16, 2023, Of the 131 equity ETFs in India, almost one-fifth have not been bought or sold in 50% of the trading days since January 2022. Worse, 12 of them have never even been traded once. Never! Now, imagine if you ended up buying one such ETF. You would either be forced to sell your investment at a discount due to low demand (a few buyers) or not be able to sell it at all, even if you need money.

This is one of the critical factors when analysing and choosing an ETF. High liquidity is essential as it ensures you can seamlessly buy and sell ETF units. Thus, you should invest in ETFs with high trading volumes, or you will find it challenging to sell all your ETF units at once if the trading activity is low. Low liquidity in ETFs can also lead to deviation between the market price of an ETF and its NAV. This can adversely impact your returns if your entry or exit price is not aligned with the NAV. 

Let’s understand the impact of liquidity on investor return using a case study. 

Case Study 

The world of ETFs is more complex than it looks from the outside. This is so because, every now and then, trading prices of ETFs might exhibit deviations from their NAVs due to the supply and demand situation in the market. This difference can have a potential impact on your returns. Let us show you how.

• Trading at a premium 

On April 11, 2023, the fund's NAV stood at ₹5,561.08, but its closing price for the same day was ₹5,725.10. Thus, the two figures have a significant difference of ₹164. if you had purchased units of this ETF on that specific day, you would have effectively paid a premium of ₹164, consequently impacting your profits when you sold that fund later. 

• Trading at a discount 

Let's move forward to May 8, 2023. The situation is different from the one discussed earlier. On this date, the difference between the NAV and the closing price of the ETF was negative, at ₹39. This means that the ETF was available at a discount. The discount may have benefitted you when buying the ETF unit, but there is no guarantee that even though its NAV rises later, you can sell it at the NAV. 

Simply put, ETF investors didn't have a clear picture of whether they were buying and selling ETFs at a premium or a discount, as the NAV data ETFs were available only after the market hours. This used to impact the overall returns of an investor. 

However, to solve this issue, in July 2022, the Securities and Exchange Board of India (SEBI) introduced a knight in shining armour: intra-day net asset value (i-NAV). This is also the NAV value of the fund; however, unlike NAV, i-NAV is available during market hours.  This updates every 15 seconds or so during the trading day, helping investors to know whether they are buying/selling ETFs at a discount or a premium. To find the i-NAV of an ETF, visit the fund house's website. Thus, checking the i-NAV of a fund will help you make smarter decisions. 

Now often, you might have a doubt about how ETF units are created and traded in the secondary market. So, let’s dive deep into the working mechanism of ETFs. 

How Are ETFs Created?

ETF shares are created by the asset management company (AMC) on request from authorised participants (AP). APs are also called market makers. The role of market makers is to regularly provide buy and sell quotes to ETF clients on the exchange. APs play a crucial role in providing liquidity in the ETF ecosystem, ensuring efficient and continuous ETF trading in the secondary market. How are they able to do so? By simply using a process of creation and redemption basket. Let’s discuss this further:

• You all know that ETF consists of a portfolio of securities. The AP purchases these underlying securities, known as the creation basket, that a particular ETF must hold.
• The AP then delivers these securities to the asset management company or fund house, receiving a block of ETF shares against it. 
• Please note that AMC specifies the basket of securities for creation/redemption daily.

For example, if an ETF tracks the Sensex, the AP buys all 30 securities in the index, i.e., the creation basket, and delivers them to the fund house. In return for such delivery of securities, the AP gets ETF shares of equivalent value. Usually created in large lots, these shares can be traded on stock exchanges. 

Other than ETFs, as discussed earlier, index funds are passive funds that aim to track a particular index to provide returns in line with those of the underlying market index. Then, what's the difference between the two? Which would you prefer? Let’s compare an ETF and index fund on certain factors critical for analysis.

ETF vs. Index Funds

• Price quotes: So far, you have understood that ETFs trade in real-time in stock markets. That is why their prices are available throughout the trading day and tend to change like any other stock price. On the other hand, index funds are like standard funds, where you only know the price, which is the net asset value, only once, i.e., after the market closes. ETFs also have NAVs that are available after market hours, but i-NAVs, in the case of ETFs, are available during market hours. 
• Premium and discount: Ideally, an ETF's price should align with its NAV. However, as discussed earlier, the mismatch between supply and demand can cause ETFs to trade at a discount or premium to their NAVs. That's not the case with index funds, where you can be sure that you will only be allotted units at the NAV.
• Liquidity: The liquidity of ETFs is an important parameter to consider while investing in them. This determines how easily you can buy or sell the ETF units. Entities named 'authorised participants' (APs) play an essential role in maintaining the liquidity of ETFs. APs create or extinguish ETF units in markets based on the demand and supply situation for an ETF. An ETF with higher demand tends to be more liquid as it has a higher trading volume. Apart from this, the liquidity of ETFs is also defined by the underlying index it tracks. ETFs tracking major indices, such as the Sensex and Nifty 50, tend to be more liquid than those following niche indices.

However, in the case of index funds or any other regular mutual fund, you are allotted units by the fund house irrespective of the fund's demand or supply situation. In the case of redemption, the responsibility also lies with the AMC to return the investment amount to you.

• Cost: The ETFs have an advantage over index funds, especially in cost. Therefore, the expenses of ETFs tend to be on the lower side in comparison to the corresponding index funds. Thus, you can benefit by investing in an ETF and saving on the returns compromised by index funds due to their higher expenses. 
• Need for a demat account: It is important to note that if you wish to Invest in ETFs, you must have a demat and a trading account. No such account is needed in the case of index funds. The maintenance charge linked with them could be an additional expense if you do not already have these accounts. If you do not wish to open a demat account, an alternative route is investing in a fund of funds (FoF) that invests in the ETF you desire. As discussed in the mutual funds classifications chapter, FoF have characteristics like regular mutual funds, irrespective of whether the underlying fund is an ETF. The drawback of FoFs is that you have to bear dual expenses: one of the FoFs and the other of the underlying fund. 

While choosing between an index fund or ETF, investors must weigh both passive avenues' pros and cons. Broadly, index funds are likely the right choice if you seek convenience. But if you want a cost advantage, ETFs will likely be the better alternative.

Now until recent times, ETFs used to track broader market indices which have been in existence for quite a long time. However, recently a new category of ETFs also referred to as smart beta ETFs has been introduced, which tracks certain new kinds of indices based on various factors of investing. Let’s understand smart beta ETFs. 

Smart Beta ETFs

You already know that there are two investing styles - Active and Passive. You either put your money on fund managers and pay them higher fees due to their active involvement in cherry-picking the securities to generate excess returns, i.e. alpha or simply invest in a market index like the Nifty and Sensex at relatively lower costs. A new category of funds, called smart beta funds, has emerged recently. It mixes passive and active strategies and aims to pick securities based on specific factors like value, momentum, quality, and volatility. 

Factors Involved in a Smart Beta Strategy

Smart beta funds generally have six factors or rules to select securities from a particular index. These factors can be used in isolation or combined to create a unique basket of securities.
The six factors are as follows:

• Value: It includes stocks with lower value for valuation ratios like price to book, price to sales, etc. 
• Volatility: It includes stocks with lower values of standard deviations and beta, which are measures of volatility. 
• Momentum: It includes stocks showing upward price action and thus considers stock’s returns in recent months. 
• Quality: It includes stocks of companies that enjoy higher returns on capital and earnings. Apart from this, companies with lower debt are usually preferred. 
• Dividend: It includes stocks that offer higher dividend yields. 

Smart beta funds combine a passive fund's market cap-based index along with active investing rules, or as smart beta funds call them, 'factors'.

For example, The Nifty 200 Momentum 30's. It's a type of smart beta fund that screens all the 200 companies in the Nifty 200 index and identifies 30 stocks with the strongest momentum. Likewise, a Nifty 100 Low Volatility 30 smart beta fund will pick the 30 least volatile stocks among the 100 companies in the Nifty 100 index. 

Since smart beta funds have adopted the combination of passive and active styles, they have recently seen an increase in investor interest, which is unsurprising. A total of 56 smart beta funds (including quant-based funds) have been launched in the last four years till December 2023, with their assets under management (AUM) increasing from a mere ₹ 1,245 crores in December 2020 to ₹ 19,912 crores in December 2023.

However, if we talk about the performance of such funds, it has been mixed so far. Let’s look at the data:

As clearly visible, while some funds like Nifty 50 Value 20, Nifty 200 Momentum 30, and Nifty 100 Low Volatility 30 have performed better than their parent indices 90% to 100% of the time, Nifty 100 Quality 30, Nifty Alpha 50, and Nifty 100 Equal Weighted have largely trailed. Please note the study is based on five-year daily rolling returns over the last five years. 

Apart from the performance, the factors defining smart beta funds can be cyclical in nature. Thus, it might underperform simple and broad index funds for long periods. Therefore, It becomes difficult to confidently say which one will work in a particular year or the next. Let’s see what data talks about. 

Although the value factor topped the charts in the recent three calendar years, it was at the bottom of the performance table in 2019 and 2020. In fact, it had a negative 13.7% return in 2019. Similarly, other factors, such as quality and low volatility dividend yield, have also experienced similar performance. 

Growth vs Dividend ETF, Which One Should You Choose?

While investing in an ETF, investors often need to decide whether to invest in an ETF that gives dividends or opt for a growth plan, i.e. one that doesn't issue dividends. Ideally, choosing an ETF that gives you dividends is not worth it. You ask why? This is because the dividend paid is part of the capital you initially invested. This means dividends are paid out of your capital. This reduces the price of the ETF and the net asset value (NAV). In addition, you need to pay attention to the benefit of compounding from staying invested. Also, remember that the dividends you will receive from ETFs are not tax efficient and thus can be taxed up to 30%.

Therefore, opting for a growth plan while investing in an ETF is a more intelligent choice than a dividend plan.

Benefits of an ETF Investing

Till now, you have gained an understanding of ETFs and how they work. However, to what kind of investors are ETFs suitable, and what benefits do ETFs offer? Let’s understand this. 

• Simplicity

Since ETFs track a market index, they are an easy and efficient way to expect market-like returns. For instance, If you are bullish about the Indian economy and want to profit from its potential, buying a Nifty or a Sensex ETF is the easiest way to achieve this goal. 

• Low cost

One of the significant benefits of ETFs is their cost efficiency against actively managed funds. Since ETFs just copy an underlying index, they do not involve any active day-to-day decision-making by a fund manager. Also, transactions in an ETF portfolio are much less than those in an actively managed fund. Hence, this dramatically reduces the cost of operating an ETF. This lower cost benefit is directly passed on to you as an investor. 

• Diversification

If you invest in individual securities, you must buy a sufficient number of companies to achieve an optimum level of diversification. However, when you invest in an ETF, you instantly benefit from diversification, as an ETF invests in multiple securities of an index it tracks. Therefore, owning even a single unit of an ETF provides you with diversification in your portfolio. Thus, you are entitled to this diversification benefit irrespective of the amount you invest. With individual securities, you must have a certain scale to reach that level of diversification. 

• Transparency

ETF prices are available to you in real time, and their portfolios are the same as the underlying market index. This helps you know what you are getting and how your investment is doing. 

Who Should Invest in an ETF?

• Ideally, any investor who believes in India's growth story and wants to benefit from the potential of Indian equities over the long term can invest in an ETF. These are a simple, hands-off way to grow your investment capital. 
• If you don't have enough time to manage your portfolio, then ETFs are a possible solution. 
• Also, if you are a new investor with little idea about stocks or mutual funds, ETFs are an excellent starting point. 
• If you are a seasoned investor, parking a portion of your corpus in ETFs can help you diversify and limit the impact of a wrong investing decision.

How To Invest in ETFs on Angel One?

1. Open the Angel One app. Go to Watchlist.
2. Search ETFs from the Search bar. 
3. Click on the ETF that you want to see. You will reach the detailed page on the ETF.
4. Once you have decided to buy the ETC, click on ‘BUY’ below. Choose whether you want to buy it in ‘One time’ or via SIP.Go to the order pad.
5. Enter the quantity of the stock that you want to buy. 
6. You can place the order on MTF, by using the ‘Pay Later’ option. 
7. You can also use advanced orders like GTT order while investing.
8. Click on ‘BUY’. You will have placed the buy order.
9. Once bought, you can track the ETF from the Positions section in ‘ORDERS’. Once the ETF is delivered, you can track it from your ‘PORTFOLIO’.

This sums up our discussion on ETFs. To conclude, ETFs are becoming a popular investment vehicle for various advantages discussed above. It provides an easy way to gain exposure to different asset classes in an easy, cost-effective, and convenient way. Investors should invest in this vehicle per risk appetite and consider the disadvantages.