Introduction of Exchange Traded Funds
An exchange traded fund (commonly referred as “ETF”) is a financial instrument or a type of security that is formed by a collection of different types of securities such as equity stocks, fixed income securities, commodities, etc. which are traded on the exchange and their prices fluctuate during each trading day as soon as the fund is purchased or sold on the exchange.
- There are many stocks, commodities, fixed income securities, etc. Trading on the stock exchange. each security has its price per unit. however, not necessarily everyone has knowledge about the fair prices or entry points into the securities or exit price points from the securities. hence, a fund is established which is run by experts in the field.
- Here, instead purchasing the stock, the investor prefers to purchase units of an exchange traded funds. Thus, such funds are financial instruments.
- The fund manages the money received from various investors & ensures minimum return according to the type of exchange traded fund.
- This basically sounds similar to mutual funds. However, these funds can be traded (i.e. purchased or sold) only during trading business days of the market.
How Does It Work?
- It all starts with the authorized participants wanting to invest in the exchange traded funds through an investment basket.
- The authorized participants approach the ETF & invest in the funds.
- The ETF issues units to the investors against the proceeds received from them. Using the proceeds, the ETF invests the same into the financial instruments as per its type or funding strategy.
- The ETF earns out of those investments & manages its expenses.
- The basket of investment reflects the stock index like the way S&P 500 index is reflected.
- The trading of the fund units is based on the Net Assets Value as on each trading day.It can be traded throughout the day. Thus, these funds carry both the features of open-ended & close-ended funds.
- Almost the exact process is followed in case of redemption of units.
Example of Exchange Traded Fund
Say, a unit of ETF has a net assets value (NAV) of $ 32. The NAV of an exchange traded fund is different than the NAV of a mutual fund. Depending on the demand & supply elements of the units in the market, the actual price of units may trade at the range between $ 31.97 / $ 32.04. It means the investors can purchase the units at $ 32.04 today or one may sell the units at $ 31.97. This difference between NAV & actual price reflects the load component.
At the time of redemption, the NAV of the fund may change according to the investment cycle of the ETF. The investor can redeem the units at prices prevailing at that time.
Types of Exchange Traded Fund
Each exchange traded fund has an underlying instrument. Thus, the exchange traded funds can be categorized into the following types:
- Equity ETFs: As the name suggests, the underlying instrument is equity stocks. Buying high value stocks may not suit the budget of each investor. Instead, one prefers to purchase units of equity-based exchange traded funds. These types of funds invest into various sectors of equities markets & earn a handsome amount from such diversification. However, one should note that the quantum of risk in such funds is higher as compared to other fund types.
- Sector-Specific ETFs: As the name suggests, such funds invest in stocks or bonds for any specific sector of the market. However, one should note that the risk in such ETFs is sector-specific.
- Commodities ETFs: Correlation of one investment with another is very important if you wish to earn huge. Investments with positive correlation are always avoided in the investment segment. A positive correlation means both returns will either give you profits or losses. The negative correlation makes you profitable at all times. The commodities market & stock market have a negative correlation. Thus, it is suggested to have some portion of investment in such ETFs as well.
- Fixed Income ETFs: These will invest in fixed income securities which has lower volatility & average risk. Due to the lower quantum of risk, the returns are also lower to that extent. Thus, the risk appetite of a person defines the quantum of investment he wants in such ETFs.
- Real Estate ETFs: The return perspective of such ETFs is higher due to the risk exposure covered in this type of ETF. It invests into real estate segments. The prices of real estate changes drastically with time. Thus, the investor is able to generate super normal profits during boom times of the real estate industry.
- Currency ETFs: Such ETFs park their money only in the currencies market. The currency market is highly volatile for changes each day. Again, the risk appetite of the investor drives the return segment in this ETF.
Criticism of Exchange Traded Fund
The common criticism received for exchange traded fund are as follows:
- Income from exchange-traded fund is treated as passive income & not an active source of income.
- Thus, it may lead to inefficiency in the financial markets.
- Too much dependency on exchange traded funds results into under-performance by the investors.
- Since ETFs are treated as passive investment vehicles, it may jeopardise the consistency of stability of the entire financial system. In turn, it may also lead to financial destruction.
- Financial destruction has an effect on the distortion of the capital base of the investor.
Some of the advantages are given below:
- There is a great level of transparency of operations as compared to hedge funds or mutual funds. This enhances the confidence level of investors.
- Many exchange traded funds provide with margin facility. This leverages the investment profile of investors.
- The transaction costs are generally lower for exchange traded funds. Also, it is observed that there are no exit fees charged on such funds.
- These fund flow in line with the index & thus they are passive funds. The costs such management cost, distribution of units cost, higher perks of manager, etc. are managed in low expense ratio as compared to mutual funds.
- They are available for trade during the entire day. Thus, the investor enjoys features such as stop loss orders, limit order types, etc. during the trading days.
- The transaction taxes are lower in the case of exchange traded funds.
- Liquidity & flexibility to trade is higher in the case of exchange traded funds.
Some of the disadvantages are given below:
- One of the types of ETFs is equity ETFs. Even there is a lot of transparency in exchange traded funds, one may not know the quantum of risk contained in the equity segment of the ETF. Thus, the investors may be exposed to unknown risk element.
- Exchange traded fund do not have the option to reinvest the amount of dividend earned. This happens to be a loss-bearing deal for investors.
- The diversification ratio of exchange traded funds is lesser as compared to normal mutual funds. Lower diversification results in a higher concentration of risk in a particular sector.
- If diversification does not affect the investor, he should invest into stocks directly. The reason is that “he is anyway going to bear the same risk, then why not a lower cost than ETF cost”.
- In a few cases, the investor may have to pay a higher amount of capital gains tax.
Exchange traded funds are basically relevant for investors with shorter horizon period who intend to implement scalp trading type of strategies due the up-scale of advantages of ETF as compared to mutual funds. On the other hand, the long-term investor may not choose to invest in ETFs. At last, it depends on the risk exposure acceptable for an investor. ETFs are sector-specific vehicles of investment & thus the risk appetite drives the return perspective of the investor. Exchange traded funds are anyways featured with a higher amount of liquidity & flexibility.
This is a guide to Exchange Traded Funds. Here we also discuss the introduction and types of exchange traded funds along with advantages and disadvantages. You may also have a look at the following articles to learn more –