ETFs are just what their name implies: baskets of securities that are traded, like individual stocks, on an exchange. Unlike regular open-end mutual funds, ETFs can be bought and sold throughout the trading day like any stock.
Most ETFs charge lower annual expenses than index mutual funds. However, as with stocks, one must pay a brokerage to buy and sell ETF units, which can be a significant drawback for those who trade frequently or invest regular sums of money.
They first came into existence in the USA in 1993. It took several years for them to attract public interest. But once they did, the volumes took off with a vengeance. As of 2020 In 2020, the assets managed by ETFs globally amounted to approximately 7.74 trillion U.S. dollars. About 60% of trading volumes on the American Stock Exchange are from ETFs. The most popular ETFs are QQQs (Cubes) based on the Nasdaq-100 Index, SPDRs (Spiders) based on the S&P 500 Index, iSHARES based on MSCI Indices .
Their passive nature is a necessity: the funds rely on an arbitrage mechanism to keep the prices at which they trade roughly in line with the net asset values of their underlying portfolios. For the mechanism to work, potential arbitragers need to have full, timely knowledge of a fund’s holdings.
Index Tracking
Index tracking has been widely acclaimed in practice and in theory as a winning strategy for long term investing. It has been the experience that globally, a majority of actively managed funds have under performed their respective benchmarks over a long period of time.
William Sharpe, a Nobel laureate in Economics, believes that all active fund managers together can never outperform the market. Consequently, all classes of investors viz. institutional and retail are increasingly moving towards investing in well-defined indices, which are professionally managed. In fact the largest mutual fund scheme today is an index fund on the S&P 500 managed by Vanguard ( Vanguard S&P 500 ETF; Ticker- VOO with AUM of $690B https://investor.vanguard.com/etf/profile/VOO )
Index Funds
An Index Fund is a mutual fund that tries to mirror a market index, like Nasdaq, S&P 500 , NSE Nifty , as closely as possible by investing in all the stocks that comprise that index in proportions equal to the weightage of those stocks in the index. These are passively managed funds wherein the fund manager invests the funds in the stocks comprising the index in similar weight. Index funds, while reducing the risk associated with the market, offer many benefits to the investors.
Firstly, the investor is indirectly able to invest in a portfolio of stocks that constitute the index. Next, they offer diversification across a multiplicity of sectors since index stocks are generally a basket of 20-25 sectors. Added to these is the relatively low cost of management. Index funds are considered appropriate for long term investors looking at moderate risk, moderate return arising out of a well-diversified portfolio.
Advantages of ETFs
While many investors have similar outlooks, no two are exactly alike. Due to the unique structure of ETFs, all types of investors, whether retail or institutional, long-term or short-term, can use it to their advantage without being at a disadvantage to others. They allow long-term investors to diversify their portfolio at one shot at low cost and insulate them from short-term trading activity due to the unique “in-kind” creation / redemption process. They provide liquidity for investors with a shorter-term horizon as they can trade intra-day and can have quotes near NAV during the course of trading day. As initial investment is low, retail investors find it simple and convenient to buy / sel and have easy asset allocation at a low cost.
ETFs provide exposure to an index or a basket of securities that trade on the exchange like a single stock. They offer a number of advantages over traditional open-ended index funds as follows:
- While redemptions of Index fund units takes place at a fixed NAV price (usually end of day), ETFs offer the convenience of intra-day purchase and sale on the Exchange, to take advantage of the prevailing price, which is close to the actual NAV of the scheme at any point in time.
- They provide investors a fund that closely tracks the performance of an index throughout the day with the ability to buy/sell at any time, whereby trading opportunities that arise during a day may be better utilized.
- They are low cost.
- Unlike listed closed-ended funds, which trade at substantial premium or more frequently at discounts to NAV, ETFs are structured in a manner which allows Authorized Participants and Large Institutions to create new units and redeem outstanding units directly with the fund, thereby ensuring that ETFs trade close to their actual NAVs.
- Since an ETF is listed on an Exchange, costs of distribution are much lower and the reach is wider. These savings in cost are passed on to the investors in the form of lower costs. Further, the structure helps reduce collection, disbursement and other processing charges.
- ETFs protect long-term investors from inflows and outflows of short-term investors. This is because the fund does not incur extra transaction cost for buying/selling the index shares due to frequent subscriptions and redemptions.
- Tracking error, which is divergence between the NAV of the ETF and the underlying Index, is generally observed to be low as compared to a normal mutual fund due to lower expenses and the unique in-kind creation / redemption process.
- ETFs are highly flexible and can be used as a tool for gaining instant exposure to the equity markets.
Recent Comments