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Understanding ETFS or Exchange-Traded Funds

ETFs or Exchange-traded funds were once described as the new kid on the investment block, but today they are competing neck-to-neck with traditional mutual funds, literally giving them a run for their money. Both ETFs and mutual funds are viable choices for investors. However, since there are many mutual funds and ETFs available on the market, it becomes important for investors to familiarize themselves with the differences between all the products and be aware of their investment decisions.

What is an ETF or Exchange-Traded Fund?

Simply put, an ETF is a basket of securities that are traded on a stock exchange, just like shares are traded in the stock market. Unlike conventional mutual funds, ETFs are listed on a recognized exchange and their units can be bought and sold directly on the exchange through a stockbroker during the trading hours. To simplify further, ETF is more like a mutual fund that one can buy and sell in real time, at a price that keeps changing throughout the day. An ETF holds assets such as stocks, commodities or bonds, and trades close to its net asset value (NAV) over the course of the trading day.

Types of Exchange-Traded Funds or ETFs

ETFs are either close-ended or open-ended.

Open-ended Exchange-Traded Funds or ETFs
  • Open-ended ETFs can issue fresh units to investors (an ongoing fund), whereas close-ended ETFs open only once during its offer date.
  • With open-ended funds, purchases and sales of fund shares take place directly between investors and the fund house.
  • There is no limit to the number of shares the fund can issue; as more investors buy into the fund, more shares are issued.
Close-ended Exchange-Traded Funds or ETFs
  • They issue only a specific number of shares and do not issue new shares as investor demand grows.
  • Prices are not determined by the net asset value (NAV) of the fund, but are driven by investor demand. Purchases of shares are often made at a premium or discount to NAV.

Type of Exchange-Traded Funds or ETFs that are being traded at a Recognized Stock Exchange

  • Equity ETF: Equity ETF is a basket of stocks that reflects the composition of an index, like the S&P BSE Sensex. The ETF trading value is based on the net asset value of the underlying stocks that it represents. Currently, there are 11 equity ETFs that can be traded on Bombay Stock Exchange.
  • Gold ETF: Gold ETF is a special type of exchange- traded fund that tracks the price of gold and where gold paper units can be bought and sold for as small as one gram of gold. (Refer to Consumer Voice article published in October 2013 issue).
  • Liquid ETF: Liquid ETFs are the money- market ETFs and their objective is to provide money-market returns. Liquid BeES launched by benchmark mutual fund is the first money-market ETF in the world. Liquid BeES will invest in a basket of short-term government securities and money-market instruments of short and medium maturities.

 

Where and How to Buy and Sell Exchange-Traded Funds or ETFs?

The buying and selling of ETFs is primarily done online in real time at the stock exchange, through a broker. There is minimal interaction between investors and the fund house.

To buy an ETF, the foremost requirement is a brokerage account. Once you have opened a brokerage account, you need to decide which ETF you want to buy by visiting the relevant section on the brokerage firm’s website – this is the section where they trade stocks and ETFs. This is where you can choose the number of shares you wish to buy as per their price and the investment you wish to make.

ETFs can be bought from an investment firm or an online brokerage company at any time when the stock exchange is open. The price of the ETF varies throughout the day and hence you will have to buy it at its ‘current market price’ at the time of the transaction.

The stock-like quality of ETFs allows an active investor to trade throughout the day. Unlike mutual funds, ETFs can also be used for speculative trading strategies, such as short selling and trading for small margins. In short, ETFs allow investors to trade the entire market as though it were one single stock.

How to Track ETF Performance

ETFs are quoted in the bourses every day until the closure of trading time. Each fund house that manages the ETFs showcases their funds’ everyday performance on their website, for public or retail investors to track the performance. The performance is primarily assessed on the basis of NAV, dividend and price graph, among others.
The dividend history is also made available by the fund house on their website. If the same is not uploaded or updated by them, the investor has the option of contacting their customer care to obtain the same. One may simply write to the customer care email IDs or call on the numbers listed on the website.

Measuring Return on Investments of ETFs

Given the fact that ETFs are market-linked and their prices are fixed on the basis of the economic scenario of the day (which is primarily affected by international political affairs as well as their own demand and supply), it has been observed that ETFs give better returns in the short term – ranging from six months to one year – rather than in the long term.

Management Fees of ETFs

Investment management fees for Exchange-Traded Funds and mutual funds are deducted by the ETF or fund company, and adjustments are made to the net asset value of the fund on a daily basis.

Exchange-Traded Funds versus Conventional Mutual Funds

Advantages of Exchange-Traded Funds

  • ETFs offer tax advantages to investors due to fewer capital gains.
  • The capital gains tax on an asset in an ETF is only paid when the entire ETF is sold, not while you are holding the ETF.
  • ETFs can be a great investment vehicle for small and large investors alike.
  • ETF investors can transact at the price prevailing at that point in time.
  • ETF investors do not have to bear any loads (as in the case of MFs) and brokerage commission is also low.

 

Limitations of Exchange-Traded Funds

  • Going by the nature of these funds, the short-term returns for such periods as three months to six months to one year are better than those by peer funds. So these funds are better investments for individuals looking for short-term gains. ETFs give lower returns if one holds on to them for a longer period.
  • A major consideration before investing in ETFs is the potential that fund companies can go bust anytime.
  • It is impossible to gauge the financial viability of a startup ETF company.
  • Brokers and sub-brokers tend to wean away potential investors from ETFs as they probably get paid less commission here than in regular MFs. Hence, one must get several opinions from various brokers before investing and try to understand the commission scenario.

Our Banking and Finance Experts compare ETF Investing of 7 ETFs  to get the best ETF stock investment option.

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