What are Exchange Traded Fund or ETFs?

This post is about Exchange Traded Fund or ETFs. It is one of the most popular types of investment funds traded on stock exchanges, like stocks. Let’s know in detail about Exchange Traded Fund or ETFs.

This post covers the following topics:

• About Exchange Traded Fund or ETFs
• Investment Uses
• Types of ETFs
• Pros and Cons of ETFs
• Some Real-World Examples of ETFs
• ETF Creation & Redemption
• Mutual Funds vs. ETFs
• How to Invest in Exchange Traded Fund

Let’s begin.

What are Exchange Traded Fund or ETFs?

In simple words, an ETF (Exchange-Traded Fund) is a type of security. It involves a collection of securities – like stocks.

An ETF can be invested in any number of industry sectors. In fact, ETFs are very similar to Mutual Funds. However, they are listed on exchanges and trade throughout the day like ordinary stock.

Example: SPDR S&P 500 ETF (SPY), NIFTY BEES (NIFTYBEES)

An ETF can contain many types of investments – such as stocks, commodities, bonds, and even a mixture of investment types.

Moreover, an ETF is marketable security. So, it comes with an associated price that enables it to be easily bought and sold.

Key Features

• It is a basket of securities that trade on an exchange (just like a stock)
• ETF share prices fluctuate all day when the ETF is bought and sold
• It can contain various types of investments such as stocks, commodities, or bonds
• ETFs come with a low expense ratio and fewer broker commissions

An exchange-traded fund is traded on the stock exchange, just like any other stock. An ETF share price can float (change) throughout the trading day as the shares are usually being bought and sold on the market.

So, ETFs are different from Mutual Funds, which are not traded on an exchange, and the mutual fund price is changed once per day when the markets close. Plus, ETFs are more cost-effective and liquid when compared to mutual funds.

An ETF can hold multiple underlying assets. So, they can be a popular choice for diversification. It can hold hundreds of stocks across various industries. For example, banking-focused ETFs can contain shares of different banks across the industry.

Investment Uses

ETFs are generally known for easy diversification, low expense ratios, and tax efficiency while maintaining ordinary stock features.

Since ETFs can be economically acquired, most investors invest in ETF shares as a long-term investment for asset allocation purposes. However, ETF shares are also traded frequently for hedging risks over short periods. Here, we have featured some of the main investment uses or advantages of ETFs:

• Lower costs: ETFs have lower costs than other investment products. They have lower marketing, distribution, and accounting expenses.
• Buying & Selling Flexibility: The flexibility with ETFs is that they can be bought & sold during current market prices, usually at any time during the trading day.

Moreover, their shares can be purchased on margin & sold short. They can be traded with stop orders and limit orders. The investors can specify the price points at which they want to trade.

• Tax Efficiency: ETFs tend to generate low capital gains. The tax efficiency is further enhanced because it is not necessary to sell securities to meet investor redemptions.
• Market exposure & diversification: ETFs offer an economical way for rebalancing portfolio allocations.

For example, an Index ETF offers diversification across an entire index.

They give various markets exposure, including broad-based international, country-specific indices, bond indices, industry sector-specific indices, and commodities.

• Transparency: ETFs come with transparent portfolios. They are usually priced at frequent intervals throughout the trading day.

Types of Exchange Traded Fund

Well, various types of ETFs are available to investors. They can be used for income generation, speculation, or to partially offset risk in an investor’s portfolio. Below we have listed several examples of types of ETFs:

• Index ETFs attempt to replicate the performance of a specific index. The indexes can be based on stocks, bonds, commodities, or currencies.
• Stock ETFs are the most popular ETFs that track stocks. They can have different styles, such as large-cap, small-cap, value, growth, etc.
• Bond ETFs include government bonds, corporate bonds, state and local bonds known as “municipal bonds.”
• Industry ETFs track a particular industry such as banking, technology, or the oil and gas sector.
• Commodity ETFs invest in commodities such as crude oil or gold.
• Currency ETFs invest in foreign currencies like the Euro or Canadian Dollar.
• Inverse ETFs tend to earn gains from stock declines by shorting stocks. Shorting is known as the selling of stock when you expect a decline in value and go on to repurchase it at a lower price.

In the U.S., most of the ETFs are set up as open-ended funds. They are subjected to the Investment Company Act of 1940. In fact, the open-ended funds do not limit the number of investors involved in the product.

Pros and Cons of ETFs

ETFs have lower average costs since it tends to be an expensive affair for an investor to buy all the stocks held in an ETF portfolio individually.

In fact, investors have to carry out only one transaction to buy and one transaction to sell.

So, it leads to lower broker commissions, as there are only a few trades that are done by investors.

Typically, ETFs have low expense ratios which are the cost to operate and manage the fund.

For instance, an ETF can track the S&P 500 Index. In fact, it can include all 500 stocks from the S&P. So; it turns out to be a passively-managed fund and less time-intensive. Having said this, not all ETFs go on to track an index passively.

Pros include:

• Access to various stocks across different industries
• Low expense ratio
• Fewer broker commissions
• Better risk management through diversification
• ETFs focus on targeted industries

Cons:

• Actively-managed ETFs have higher fees.
• There are some single industry-focused ETFs that limit diversification.
• Lack of liquidity hampers transactions

Some Real-World Examples of ETFs

Here, we have shared some examples of the most popular ETFs on the market today. Some ETFs go on to track an index of stocks, while others do target specific industries.

• SPDR S&P 500 (SPY): It is the most widely known ETF that tracks the S&P 500 Index
• SPDR Dow Jones Industrial Average (DIA): It represents the 30 stocks in the Dow Jones Industrial Average
• iShares Russell 2000 (IWM): It tracks the Russell 2000 small-cap index
• Commodity ETFs: It represents the commodity markets that include crude oil (USO) and natural gas (UNG)
• Sector ETFs: They track individual industries, including oil, energy, financial services, Biotech, etc
• Physically-Backed ETFs: It includes the SPDR Gold Shares (GLD) and iShares Silver Trust (SLV), which hold physical gold as well as silver bullion in the fund
• NiftyBees: This ETF holds 50 Stocks of Nifty India.

ETF Creation & Redemption

ETF shares are regulated by a mechanism known as Creation and Redemption. It involves large specialized investors that are being called Authorized Participants (APs).

Creation

When additional shares are to be issued, the AP goes on to buy the shares of the stocks from the index (including the S&P 500) and sells or exchanges them to the ETF by new shares with an equal value.

After that, the AP goes on to sell the ETF shares in the market for a profit. This process, which involves the AP selling stocks to the ETF sponsor in return for shares in the ETF, is known as Creation.

Redemption

An AP can also buy shares of the ETF on the open market. The AP can sell these shares back to the ETF sponsor in exchange for individual stock shares. In fact, the AP goes on to sell them in the open market. The result is that the number of ETF shares is reduced through the process, which is known as Redemption.

In fact, the redemption and creation activity is depended upon the demand in the market. It also depends on the fact that the ETF is trading at a discount or premium compared to the value of the fund’s assets.

Mutual Funds vs. Exchange Traded Fund

Mutual Funds and ETFs are both examples of pooled fund investing. They often adhere to a passive, indexed strategy that can track or replicate the representative benchmark indices.

The characteristic of pooled funds is that they bundle securities together and offer investors the benefit of a diversified portfolio.

So, the concept of a pooled fund is primarily focused on diversification and follows economies of scale. They allow managers to decrease the transaction costs by following large lot share transactions with pooled investment capital.

Key Takeaways

• The Mutual funds and ETFs offer investors pooled investment product options.
• Mutual funds have complex structuring as compared to ETFs with varying share classes and fees.
• Mutual funds are beneficial for investors as they offer a wide selection of actively managed funds, whereas ETF appeals to investors as they go on to track market indexes.
• Mutual fund trading closes at the end of the trading day, while ETFs are actively traded throughout the trading day.
• Mutual funds are actively managed, while ETFs are passively managed investment options.

Some Similarities

Both Mutual Funds and ETFs come with anywhere from 100 to 3000 different individual securities within the fund. Both these investments are primarily regulated by the three principal securities laws that came into force after the market crash of 1929 (USA).

• Securities Act of 1933 (USA)
• Securities and Exchange Act of 1934 (USA)
• Investment Company Act of 1940 (USA)

Both these investment products are built from the same pooled fund concept. The same principle securities laws also regulate them.

Moreover, income from Mutual Funds and ETFs are taxable. Investors need to pay either the short-term or long-term capital gains tax when they sell their shares for a profit.

Plus, investors need to pay taxes on any dividends they receive from their holding of Mutual Funds and ETFs.

However, Mutual Funds have higher tax implications than ETFs as they go on to pay investors capital gains distributions. The capital distributions that the mutual fund pays out are taxable.

Typically, ETFs do not make the payout of capital distributions. So, ETFs hold a slight tax advantage over Mutual Funds.

When comparing these two investment products, ETFs do hold the edge over Mutual Funds with their combination of low costs, ease of access, and emphasis on index tracking.

If your goal is to accumulate long-term wealth using a diversified portfolio, then ETFs are certainly a better choice than Mutual Funds.

How to Invest in Exchange Traded Fund?

Here are the following points before investing in ETFs in India:

• You should open a trading account with a broker/sub-broker
• You should also take a Demat account for holding the ETF units

To complete these formalities, you have to become KYC Compliant and furnish the following documents:

• Proof of Identity: PAN Card, Passport, Driving License
• Proof of Address: Passport, Utility Bill
• Bank Account Details: Bank Account Statement

Once you complete the above formalities, you can begin to buy and sell ETFs through your account.

Here, we have listed out the ways by which you can invest in ETFs:

• You can buy or sell ETF units through the broker using the telephonic mode
• You can place orders on the online trading terminal that the broker provides

Once you have purchased the ETF, it will be credited to your Demat account. When you need to sell the ETFs, you can sell them using your trading interface like any other equity.

If you place an offline order, you need to make sure that the DIS is deposited on time.

You must know that the entire process of debit to your Demat account is maneuvered in real-time. On T+2 day, the proceeds of your sale will get credited to your designated bank account.

So, you see that Exchange Traded Funds (ETFs) are a resourceful product for investing across asset classes. We hope that the post is useful to you. Thanks for visiting. We welcome your comments and suggestions.