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PFP Primer: What are ETFs?


In simple words, ETF or Exchange traded funds are index funds that trade on stock exchanges like shares. An ETF allows you to buy and sell an entire index like a stock.

ETFs provide diversification with a single investment and limited amount of capital and at a small cost. Let’s say you want to take exposure to Nifty 100 benchmark. To be able to do that, you will have to purchase 100 stocks in different proportions as in the index. This will require a lot of time and capital. With ETF, you can even purchase a single ETF unit or share and achieve this diversification. Each ETF units is typically 1/10th or 1/100th of an index.

If you believe that Actively managed funds will struggle to beat their benchmarks consistently over the long term (generating alpha or excess return is difficult), then ETFs are the right investment products for you. ETFs provide you a low cost way of investing in the benchmark.

ETFs are available for a wide variety of indices. You have large cap ETFs, midcap ETFs, sectoral ETFs, smart beta ETFs, gold ETFs, Bond ETFs and many more. An ETF can be constructed for any index.

Here is good video on how ETFs work.

How are ETFs different from mutual funds?

ETFs are passively managed i.e. there is no fund manager who selects the securities to buy and sell. The aim is to merely replicate/track the index (and not beat it). For instance, a Nifty 50 ETF will merely try to replicate the performance of Nifty 50. As and when the constituents of the index change, the constituents of the ETF will also change.

Actively managed mutual funds will aim to beat the benchmark index. By the way, there are passively managed index mutual funds too whose aim is also to merely track the benchmark index.

Since the ETF will have small operational and management expenses attached, the performance will be slightly inferior to the benchmark. This difference between the index and ETF returns is also known as Tracking error. By the way, the management cost is not the only reason for tracking error.  The ETFs have to regularly rejig portfolio based upon the changes in the benchmark index and the timing and volume of such purchases or sales can introduce some tracking error.

Here is the performance of SBI Nifty 50 ETF.

What are ETFs
Performance of SBI Nifty 50 ETF Source: ValueResearch

You can see that the SBI Nifty 50 ETF lags the benchmark Nifty 50 TRI slightly.

Since there is no fund manager involved (no active management), there is no fund manager. If you constantly worry that your fund is struggling to the beat the benchmark, then ETFs are a great investment for you. With ETFs, you will get benchmark returns. There is no fund manager risk.

The expense ratio of an actively managed mutual fund is typically between 100 bps to 250 bps.  A passively managed index fund will cost you up to 50 bps. A basis point (bps) is 0.01 percent. On the other hand, an ETF is likely to cost you between 5 bps and 25 bps.

I sorted the list of large cap funds on ValueResearch website on the basis of expense ratio. As you can see, ETFs and index funds dominate the list.

SBI ETF Nifty 50 low expense ratio  ETFs index funds low cost investing
Source: ValueResearch

Index funds are passively managed mutual funds. Like ETFs, they also try to mirror the benchmark.  However, the expense ratio of index funds is typically higher than ETFs (for the same benchmark). As I understand, this is due to the way ETFs and index funds work. With index funds, you buy and sell from the fund house. Not only does this entail extra operational work but also transactional work. This, I believe, will also add to the tracking error. In case of ETFs, you buy and sell from the other investors (and not from the AMC).

In case of ETFs, there is no concept of commissions. Everything is, in a way, direct. Actively managed funds and index funds can available under both Direct and Regular variants.

There is no concept of exit load either in ETFs. You can buy and sell whenever you want without any exit penalties.

With ETFs, you can buy and sell at any point during the trading day (just like stocks). Therefore, you will have multiple purchase and sell prices during the day in case of ETFs. On the other hand, in case of mutual funds, you can only buy or sell at day end NAV (that is announced by the AMC after the market closes).

You may have seen that markets sometimes correct sharply only to recover by the end of the day. With mutual funds, there is no way to benefit from such intraday movements. You will only sell or purchase at day end NAV. However, with an ETF, you can buy when the markets move down and sell when the markets go up the very same day (or even hold for longer term). Even though it is easier said than done, ETFs provide you the flexibility, nonetheless.

With ETFs, you buy or sell from other investors/traders like you. In case of mutual funds, you buy from or sell to the fund house.

What are the issues with ETFs?

  1. You have to purchase ETFs on the stock exchange just like stocks. Therefore, there will be brokerage involved when you transact in ETFs. A high brokerage can lower the cost benefits of ETFs, especially if you churn your portfolio (or trade often). Let’s say a Nifty 50 Index Fund costs 25 bps while a Nifty ETF has an ETF of 5 bps. You save 20bps every year by investing in ETFs instead of index mutual funds. However, if you pay 50 bps as brokerage while purchasing the ETF, then you have essentially given away the cost benefit of 2.5 years. Frequent churning of the portfolio will add to such brokerage costs. Fortunately, there are discount brokerage options available that can reduce your cost of ETF ownership.
  2. Liquidity in the secondary market can be a problem. Since you have to exit by selling on an exchange, low liquidity can be a problem. Liquidity, in an ETF counter, is also dependent on the size (AUM) of the ETF. You can expect ETFs with larger AUMs to have higher trading volumes and better liquidity. No guarantee though.
  3. As things stand today, the AUMs and the trading volumes are quite low for most ETFs. This can add to impact cost (high spread between bid and ask prices of a security) while buying or selling. This will affect your net returns.
  4. By the way, the liquidity of an ETF also depends on the liquidity in the underlying securities. It is quite possible that a small ETF (lower AUM) can have good liquidity. This paper looks at this aspect in great detail. The liquidity will essentially depend on whether market makers and Authorized participants are actively providing liquidity in that particular ETF.
  5. ETF price can be different from the NAV (or the value of the underlying assets). Since ETF’s trade on the stock exchanges, there is potential for deviation from the NAV. Ideally, the ETF price should not be very different from the NAV because that will present an opportunity for arbitrage. You must avoid ETFs with large difference between price and NAV.
  6. You can hold ETFs unit only in demat. Therefore, you will have to open a trading and a demat account to transact in ETFs. You can invest in mutual funds without opening a demat account.

How are ETFs taxed?

Depends on the asset class.

An equity ETF will be taxed like a stock or an equity mutual fund. Short term gains (holding period <= 1 year )shall be taxed at 15% while the long term gains shall be taxed at flat 10% (LTCG of Rs 1 lacs per year is exempt).

A debt ETF or a gold ETF will get the tax treatment of a debt fund or gold respectively. Short term capital gains (holding period <=3 years) shall be taxed at your marginal tax rate (tax slab). Long term capital gains shall be taxed at 20% after indexation.

Do note tax liability arises only at the time of sale of ETF units.

How do I purchase ETFs?

You are purchase ETF units in two ways:

  1. At the time of initial offering: When the mutual fund house (AMC) makes a primary offering (New fund offer or Further fund offer)
  2. In the secondary markets (on the stock exchanges): You can buy (or sell) ETFs on the stock markets just like a stock. ETFs trade all day like a stock.

Types of ETFs available

ETFs are not just about equities. ETFs are available for the asset classes. In India, the range of choices is relatively limited.  Still, you have ETFs for prominent equity benchmarks such as Nifty. You have sectoral ETFs. For instance, there are ETFs that track Bank Nifty. If you are bullish on a particular industry, you can take exposure through such ETFs.

There are Gold ETFs. There are ETFs for Government Bonds. There are a few ETFs for global indices too such as Hangseng and Nasdaq. You can check the list of actively traded ETFs on NSE website.

Should you invest in Equity markets through ETFs?

As an investor, you first need to decide whether you want to invest passively or actively.

A passively managed fund (index fund or ETF) can never generate alpha (excess return). You will only get benchmark returns.

Therefore, if thrive on beating Nifty, Sensex or any other benchmark, the ETFs are not for you.

If you are someone who always wants to be in best performing fund, the ETFs are not for you.

If you can’t withstand your friend’s portfolio outperforming yours, the ETFs are not for you.

You must understand what ETF can or cannot do before you choose to invest in ETFs.

An ETF’s performance will mirror the benchmark’s performance. There will be times when actively managed funds will beat ETFs (a large cap fund outperforming a Nifty 50 ETF). There will be times when actively managed funds will underperform ETF performance. There will be a few funds that will beat ETFs handsomely over the long term (though you can only tell this in hindsight). You must be fine with this.

If you want to invest in ETFs, you must have faith in that benchmark and the patience and discipline to ignore all the noise.

What do I think?

In my opinion, with SEBI rationalization and categorization of mutual fund schemes, it would be difficult for actively managed funds to beat the benchmark (Total returns index) consistently over the long term in the large cap space. It is not that no actively managed fund will outperform the benchmark over the long term. I am sure many funds will. Just that, sitting today, it is not easy to tell which those funds will those be. Therefore, a low cost index fund or ETF is good way to take exposure to large cap stocks.

In the mid and small cap space, I believe there is a scope for outperformance over the long term through security selection. Therefore, active management can add value in this space. In any case, as of today, there are very few index funds or ETFs in the mid and small cap space. One of the reasons could be that AMCs (fund houses) do not want to cannibalize their actively managed funds.

Remember the AMCs earn way more money in case of actively managed funds because they can charge higher fees for active management. Another reason is the liquidity in the underlying securities of a mid or small cap ETF. If there is not enough liquidity in the underlying stocks (which may be the case with underlying stocks in mid and small cap indices), then the tracking error of the ETF can be higher or can impact market-making activity in the ETF, if any.

The interesting part is that NSE and BSE have launched strategy indices. Typically, index weights depend on the market cap of the stocks. Strategy indices (or smart beta indices) are constructed based on volatility, quality, alpha, beta, liquidity, dividend yield, growth, value or a mix of these factors. You can read more about the NSE and BSE indices on their respective websites. In this post, I will not go into the utility of such indices. ETFs are not available for all such indices. However, there are a few ETFs that track smart indices which have offered better risk-reward as compared to popular benchmarks such as Nifty and Sensex (market cap based indices). You can consider investing in such ETFs too.

Do note that this is not a recommendation to invest in these smart beta ETFs. I just want to highlight the available options. At present, there are no index fund schemes (at least I am not aware) that let you take exposure to these smart beta indices.

Keep these things in mind while selecting ETFs

While selecting ETFs, focus on larger AUM and the higher trading volumes. More importantly, focus on the difference between the ETF price and the NAV. You can get this information on ValueResearch website.

By the way, you can have multiple ETFs for the same benchmark. For instance, there are multiple Nifty 50 ETFs. Almost 5-10 AMCs have launched Nifty 50 ETFs. The risk-return profile of each Nifty 50 ETF will be same. As an investor, you need to select the one with low price-NAV difference, low impact cost and with comfortable trading volumes.

If you have decided to invest in ETFs, here are a few things that you must keep in mind.

  • Select the appropriate benchmark to invest (you need to decide that)
  • Low Expense Ratio (Can check on ValueResearch)
  • Low Tracking Error  (Check on ValueResearch). Very important
  • Low gap between ETF price and NAV (This is extremely important. You can check this on ValueResearch website)
  • Higher Assets under management (Available on ValueResearch)
  • Higher trading volumes (Check on NSE website)
  • Reduce trading costs. Work with a discount broker.

If you can’t find ETF for the desired index with low price-NAV gap and reasonable trading volumes, it will be better to take exposure to such an index through an index fund.

SBI Nifty 50 ETF (AUM: Rs 42,708 crores as on December 31, 2018)

SBI ETF difference between ETF and mutual funds
Difference between ETF and index funds

SBI ETF Nifty Next 50 (AUM: 22 crores)

You can see that the there is a huge difference between AUMs of Nifty ETF and Nifty Next 50 ETF. However, there is not much difference in bid-ask spreads. The bid-ask spread is about 0.5%, which is not small. Moreover, trading volumes of Nifty50 ETF are not proportionally large (as compared to SBI Nifty 50 ETF).

Reliance NV20 ETF (AUM: Rs 16 crores)

Reliance NV20 has lower volumes. The bid-ask spread is also about 1%. Price and NAV difference also looks substantial.

I do not have much experience with ETFs. If there are any factual inaccuracies in the article, please write to me or point out in the comments section.

8 thoughts on “PFP Primer: What are ETFs?”

  1. ETFs can also be purchased directly from the AMC,, however they have a bucket size which we need to dhere to, further you can also request them to execute the order at a particular index level..
    Index funds eliminate security selection risk

    1. Thanks Deepesh for pointing this out.
      Purchasing directly from the AMCs is not really an option for retail investors.

    2. Well explained.
      As for the comment “Index funds eliminate security selection risk”, security selection risk should be same for equivalent Index fund or ETF.
      Wonder how big in rupees are the bucket size for direct purchase.

      1. Thanks John. That depends. You can check with the respective AMC.
        For SBI Nifty ETF, it is in excess of Rs 50 lacs.

  2. A crisp and neutral post. Good insights sprinkled throughout the article. As rightly pointed out one should be mindful of overall expenses (expense ratio plus transaction cost) of ETFs vis a vis index funds apart from other parameters.

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