ETFs: Why so popular? | Types | Pros and Cons
- 18 August 2020 | 902 Views | By Abhinav Mishra
The mutual funds have been the go-to investment option for people who don’t have much understanding of the stock market and are looking for good returns on their investment. However, if you read investment books of recent times, you will find it advisable to invest in ETFs. The ETFs started in the early 1990s and they became popular very soon in the west. The basic idea of ETF was to combine the benefits of stocks and mutual funds in a single product so investors can better handle their portfolio.
In this article, we are going to see in and out of the ETFs and why you should invest in ETFs.
What is an ETF?
ETF stands for Exchange Trade Funds. An ETF is an array of investments like bonds, stocks, and commodities and in some cases combination of these assets. The primary purpose of ETFs is to quickly buy a collection of assets that provides diversification without the risk and hassle of buying each individual stock.
ETF providers set up a fund to track the performance of a particular index and buy the underlying assets in that index. The provider sells shares in that fund to individual investors. When you buy an ETF, you own a portion of the fund but not the underlying assets.
Suppose you have been tracking bank nifty and you have been impressed by its returns. Now you want to make similar returns – then you have to invest in all those shares that are present in the bank nifty. You have to buy all those shares at a time and sell at the right time, which comes with a high brokerage for every transaction and high-value investments. Instead, you buy a single ETF, your investment will automatically diversify and there is no need for a huge investment. You can invest as little as a single ETF share cost.
How is ETF created?
A financial institution can plan out the ETF, then they will decide what assets they want to include and the number of shares it will be purchasing. The ETF then goes for approval to the body that monitors stocks, Securities and Exchange Commission (SEC) in the U.S and SEBI in India. Once the approval is received, the financial institution can start buying the shares of the ETF with the help of Authorized Participant (AP). Technically, anyone can participate in this form of buying stocks but usually, AP who has huge buying capacity buys the stock. The AP has thousands of shares of the ETF and they can trade those shares in the open stock market, where individual investors can buy the shares from them.
Creation and Redemption process in ETFs
Let us consider an example of ETF which is designed to track the NIFTY Index in India. This ETF is nothing but the collection of different stocks in the NIFTY Index in the same proportion. So just like mutual funds, it has a NAV. But unlike mutual funds, it is traded in the open market so its price will fluctuate during the trading window.
Now say, for example, many investors want to buy this ETF, the price of the ETF share will rise and it may rise above the value of its underlying securities. In this case, AP comes into the picture, and knowing the ETF is overpriced, the AP can buy up the underlying shares in the ETF and then sell ETF shares in the open market. This will drive the ETF’s share price back towards fair value and in this process, AP earns a risk-free arbitrage profit.
If the ETF starts trading at a discount to the securities it holds, the AP can buy X shares of that ETF on the cheap and redeem them for the underlying securities, which can be resold. The AP drives the price of the ETF back toward fair value by buying up the undervalued ETF shares, once again making a nice profit.
What are the different types of ETFs?
The different types of ETFs are:
Equity Funds – Most ETFs track equity sectors or indexes. Most of the index ETFs completely replicate the index and some use representative sampling. If you want to capture a particular portion of the world’s stocks, a niche market, or a broad sector, you will find the corresponding ETFs.
Fixed Income – Ask any financial advisor and he will ask you to diversify your portfolio by investing in fixed income securities such as bonds. You can invest in fixed income through ETFs.
Commodity – Commodity ETFs are similar to industry ETFs where they target certain areas or sectors of the market. You can purchase a commodity ETF like gold or oil. When you buy gold ETF, you physically don’t buy the gold but you are still investing in gold.
Currency ETFs – Foreign currency ETFs help investors gain exposure to foreign currencies without completing complex transactions. You can also invest in currency ETF which tracks a basket of currencies, giving you access to multiple foreign currencies.
Real Estate ETF – Given the interest rates are very low, it is a good option to invest in Real Estate Investment Trust (REIT) ETFs. The biggest attraction of these funds is they must payout 90% of their taxable income to shareholders.
How are ETFs and mutual funds different?
You already know both options give you the option to diversify your investment. However, both are different in many aspects:
Settlement time – As mentioned above, ETFs trade in the trading window while the mutual funds trade at the end of the day. You get the mutual fund NAV at the end of the day.
Order placement – With mutual funds, placing order and redemption of your units is a two-day process (in most cases). ETFs work just like a stock, you can buy and sell ETFs with a click of a button.
Expense ratio – ETFs have a lower expense ratio than most mutual funds. This helps you as an investor with higher returns over a long duration. However, it is important to know there is a trading cost for ETFs, if your broker charges high brokerage for trading, your profit will reduce.
What is tax implication in ETFs?
Tax implications for index ETFs and sectoral ETFs – For tax purposes, sectoral ETFs and index ETFs are treated in the same way as equity funds. If held for less than 1 year, any gains will be classified as short term capital gains and taxed at 15%. If these ETFs are held for a period over 1 year then it becomes long term capital gain and is tax-free in the hands of the investor.
Tax implications for Gold ETFs and International ETFs – For tax purposes, international and gold ETFs are treated as non-equity products, meaning it will be short term gains if held for less than 3 years and will be taxed according to your tax bracket. If held for more than 3 years then it will be long term capital gains and will be taxed at 10% of gains or 20% of indexed gains, whichever is lower.
How to choose the best ETF?
There are a lot of ETFs available in the market. You must be wondering which one to choose. You must perform below exercise before investing in an ETF:
Preferred Benchmark – You have seen there are different types of ETFs you can invest in. So the first task for you is to decide if you want to invest in the main indices, banks, commodities, or something else.
High trading volume – One of the primary reasons you invest in ETF is liquidity, but if you are investing in ETF with the low trading volume you may find it hard to sell your holding. Also, low trading volume will result in higher bid-ask spread, leading to more cost of investment. You should always choose one with a high traded volume.
Low tracking error – Let us say you decide to invest in ETF which tracks the NIFTY 50 index. You know, for example, the NITFY has appreciated 12 percent in the last year. The ETF you are looking to invest in has appreciated by 11.75% over the same time period. This difference is known as tracking error. You should always pick ETF with a minimum tracking error. ETFs with over 2% tracking are risky and should be avoided.
Low Expense ratio – Always chose an ETF with a low expense ratio.
What are the pros and cons of ETFs?
Based on information shared so far, you can conclude ETFs has the following:
- more liquidity
- lower fees and expenses
- real-time buying
- the brokerage charge every time you buy a unit
- cannot invest in ETFs through SIP
Are ETFs safer than stocks?
The problem with buying a stock is it is very difficult to predict the future of it. Unless you are spending a good time in market research and following the stock quarter to quarter, you can incur heavy losses. The portfolio of ETF consists of several stocks, hence it gives the advantage of diversification. A particular stock can fall 80 to 90% or even more but you will never see free falling ETF. Hence ETFs are less risky than direct stocks.
Are ETFs good for the long term?
You know ETFs are better than stocks, now the question is are they better for the long term too? Today you may invest in a stock that is fundamentally strong and showing good results for the past few years. You decide to hold this stock for a long term period say 10 years. 10 years is a lot of time because the business fundamentals of individual stocks may go down with time – the management can change or the company’s profit can reduce significantly because of some competition. However, the fundamentals of Index never change – for example for Bank Nifty. Why? It is because the index always includes only the best stocks. So in the long run your investment is more secure under ETF than in stocks.
Are ETFs good for beginners?
A beginner who is interested in stocks but has very limited knowledge of investing and investment should always consider investing in ETFs than individual stocks. Since you have limited knowledge, the risk factor reduces significantly once you decide to invest in ETFs.
What are the safest ETFs to buy?
If you are looking for a safe option then you should also be prepared for lower returns. The safest ETFs in different categories are:
Nippon India ETF Nifty NeES (EQUITY) – tracks Nifty 50 and has delivered 14.46% returns over the last 3 years (as of December 2019).
You can also consider debt ETFs like Nippon India ETF Liquid BeES which has delivered a 5.45 % return over a period of 5 years.
Another good option is Gold ETF like HDFC Gold Exchange Traded Fund which has delivered 14.13% CAGR over the last 5 years.
What are the best ETFs in India?
Based on these parameters – Annualised 3 Year Return (%), Volume – Average Daily Trading Volume (3m average), Tracking Error- Tracking Error (w.r.t last 1-year return) and Total Expense Ratio (%), the top 3 ETFs are Edelweiss ETF – Nifty 50, HDFC Nifty 50 ETF and LIC MF ETF Nifty 50.
If you have not started investing in ETFs as of now, you should definitely consider it now.
Check out these articles to explore more about ETFs: