Exchange Traded Funds (ETFs) – Stock-like Trading

Introduction

Exchange Traded Funds (ETFs) are one of the most innovative financial products that have gained immense popularity globally. As the name suggests, these are mutual funds that trade on stock exchanges just like ordinary shares. They combine the best features of two worlds: the diversification of a mutual fund and the real-time trading capability of a stock.

What is an ETF?

An ETF is a passive mutual fund scheme that tracks a specific index (like Nifty 50, Sensex, or Gold). It holds a basket of securities in the exact same proportion as the index it tracks.

Key Mechanism:

• Creation: The AMC creates units representing the index.
• Listing: These units are listed on NSE/BSE.
• Trading: Investors buy and sell these units in real-time during market hours (9:15 AM to 3:30 PM) using their demat accounts.
• Price: The price changes every second based on demand and supply, closely tracking the value of the underlying assets (iNAV).

Key Features of ETFs

1. Real-Time Liquidity

Unlike normal mutual funds where you get only end-of-day NAV, ETFs allow you to buy or sell at any moment during market hours. You can buy at 10:00 AM and sell at 2:00 PM if you wish (intraday trading).

2. Lower Expense Ratio

Since ETFs are passively managed (they just copy the index), they don't need expensive fund managers or research teams. This results in a significantly lower expense ratio (often < 0.10%) compared to active funds (~1.5% - 2.0%).

3. Demat Account Mandatory

To invest in ETFs, you must have a Demat and Trading account. You cannot buy ETFs directly from the AMC with just a bank account (unlike normal mutual funds).

4. Transparency

You know exactly what you are holding because the portfolio is identical to the index (e.g., Nifty 50).

Gold ETFs: A Special Category

In India, Gold ETFs are very popular.

• Underlying Asset: 99.5% pure physical gold.
• Unit Value: 1 Unit of Gold ETF typically represents 1 gram or 0.01 gram of gold.
• Benefit: Investors can buy "electronic gold" without worrying about purity, storage, theft, or making charges associated with physical jewelry.

Comparison: ETF vs Index Fund vs Active Fund

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Creation and Redemption Mechanism (Authorized Participants)

How does the ETF price stay close to the Index value?

• Role of Authorized Participants (APs): Large institutions appointed by the AMC.
• Arbitrage:
  • If ETF Price > Index Value (Premium): APs buy underlying stocks, create new ETF units with AMC, and sell them on exchange to bring price down.
  • If ETF Price < Index Value (Discount): APs buy cheap ETF units, redeem them with AMC for underlying stocks, and sell stocks to push price up.
• This continuous arbitrage ensures ETF market price tracks the NAV closely.

Exam Notes: Writing the Answer

Question: "Define Exchange Traded Fund (ETF). State its advantages over open-ended mutual funds." (10 Marks)

Model Answer:

Definition: An Exchange Traded Fund (ETF) is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. Unlike regular mutual funds, an ETF trades like a common stock on a stock exchange.

Mechanism: It undergoes price changes throughout the day as it is bought and sold.

Advantages over Open-Ended Funds:

1. Real-Time Trading: Can be bought/sold at live prices during market hours (Open-ended funds transact only at Day-End NAV).
2. Lower Costs: Usually have lower expense ratios due to passive management.
3. No Lock-in: Instant liquidity (T+1 settlement) on the exchange.
4. Transparency: Portfolio is always known (Index application).

Disadvantages:

1. Brokerage Cost: Every transaction incurs brokerage and demat charges.
2. Demat Mandatory: Cannot invest without a demat account.

Conclusion: ETFs are ideal for cost-conscious investors who want passive market exposure with the flexibility of stock trading.

Quiz Time! 🎯

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