What is an exchange traded fund and how does it work?

Investors looking for exposure to an index may consider this ETF investments as an option. Exchange traded funds are one of many Types of Mutual Funds available today and is growing in popularity among different types of investors. While you may be familiar with stock funds, debt funds, or balanced funds, ETFs are another class of mutual funds that work a little differently. ETFs are mutual funds designed to mimic popular market indices like Nifty 100, BSE 100, Sensex, etc. These are passively managed funds that simply hold the stocks of the index they are designed to track in exactly the same proportion as the index. Because the fund managers do not make active security selection decisions by owning the same stocks that are included in the index, these funds are passively managed.

Exchange Traded Funds are suitable for first-time investors who want to test the waters and may not be comfortable with the higher risk that comes with regular mutual funds.

There are several advantages to investing in an ETF. First, because they are passively managed, they make fewer transactions compared to actively managed funds, which require the fund manager to constantly look for securities that can help them outperform the system’s benchmark. This results in higher portfolio turnover and hence higher tax incidence. Funds pay taxes such as STT (Securities Transaction Tax) and Capital Gains Tax when buying or selling securities in their portfolio. ETFs are therefore more tax efficient and have lower costs incurred through fund management.

Second, ETFs also typically have a lower expense ratio compared to actively managed mutual funds, which must employ highly skilled fund managers to generate active returns.

Third, ETFs offer investors greater convenience and liquidity because they are listed on exchanges and traded like stocks. Investors can step in ETF fund any time during market hours at real-time prices, unlike actively managed mutual funds, where the NAV is only calculated once a day after market close.

ETFs offer better diversification because they contain all the securities included in the index, which are rebalanced regularly. However, the lower risk that comes from greater diversification in exchange traded funds comes at the cost of potentially lower returns compared to other mutual funds. Actively managed mutual funds are more likely to produce better returns over the long term than passively managed funds because the fund manager uses his expertise and actively takes calls to buy better-performing stocks and sell underperforming stocks. But in the case of an ETF that tracks an index, all types of stocks are held, including the underperformers.

ETF investors should consider funds with lower tracking error as a key performance indicator. Tracking error shows a fund’s return deviation from its benchmark. Since these funds mimic their respective indices, the tracking error should be close to zero. However, zero tracking error is impossible because it has to buy or sell securities to match the index when the index is rebalanced and therefore bear some transaction costs. However, indices have no such limitations. Investors who value a lower expense ratio and higher liquidity may consider adding ETFs to their investment financial planning.