What is an Exchange Traded Fund (ETF)?

An ETF, or exchange traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. An exchange-traded fund (ETF) is a pooled investment security that can be bought and sold like an individual stock. ETFs can be structured to track anything from the price of a commodity to a large and diverse collection of securities.

In the simple terms, ETFs are funds that track indexes such as CNX Nifty or BSE Sensex, etc. When you buy shares/units of an ETF, you are buying shares/units of a portfolio that tracks the yield and return of its native index. The main difference between ETFs and other types of index funds is that ETFs don't try to outperform their corresponding index, but simply replicate the performance of the Index. They don't try to beat the market, they try to be the market.

Unlike regular mutual funds, an ETF trades like a common stock on a stock exchange. The traded price of an ETF changes throughout the day like any other stock, as it is bought and sold on the stock exchange. The trading value of an ETF is based on the net asset value of the underlying stocks that an ETF represents. ETFs typically have higher daily liquidity and lower fees than mutual fund schemes, making them an attractive alternative for individual investors.

ETFs have a Passive texture of Management

ETFs are passively managed. The purpose of an ETF is to match a particular market index, leading to a fund management style known as passive management. Passive management is the chief distinguishing feature of ETFs, and it brings a number of advantages for investors in index funds. Essentially, passive management means the fund manager makes only minor, periodic adjustments to keep the fund in line with its index. An investor in an ETF do not want fund managers to manage their money i.e., decide which stocks to buy/sell/ hold), but simply want the returns to mimic those from the benchmark index. Since buying all scrips that are part of say, the Nifty (which has 50 scrips) is not possible, one could invest in an ETF that tracks Nifty.

This is quite different from an actively managed fund, like most mutual funds, where the fund manager ‘actively’ manages the fund and continually trades assets in an effort to outperform the market.

Because they are tied to a particular index, ETFs tend to cover a discrete number of stocks, as opposed to a mutual fund whose scope of investment is subject to continual change. For these reasons, ETFs mitigate the element of "managerial risk" that can make choosing the right fund difficult. Rather than investing in an ‘active’ fund managed by a fund manager, when you buy shares of an ETF you're harnessing the power of the market itself.

ETFs are cost-efficient

Because an ETF tracks an index without trying to outperform it, it incurs lower administrative costs than actively managed portfolios. Typical ETF administrative costs are lower than an actively managed fund, coming in less than 0.20% per annum, as opposed to the over 1% yearly cost of some actively managed mutual fund schemes. Because they have lower expense ratio, there are fewer recurring costs to diminish ETF returns.

However, ETFs, like any other financial product, is not a one-size-fits-all solution. Examine them on their own merits, including management charges and commission fees, ease of purchase and sale, fit into your existing portfolio, and investment quality.

Structure of ETFs (source: NSE)

How do ETFs Work?

The assets that are underlying are owned by the fund provider, who then forms a fund to track the performance and offers shares in that fund to investors. Shareholders own a part of an ETF but not the fund's assets.

Investors in an ETF that tracks a stock index may get lump dividend payments or reinvestments for the index's constituent firms.

An ETF must be registered with the Securities and Exchange Board of India. In India, most ETFs are set up as open-ended funds.

Types of ETFs

• Index ETFs: These are funds that are designed to track a specific index.
• Fixed Income ETFs: These funds are designed to provide exposure to nearly every type of bond available.
• Sectoral ETFs: ETFs are designed to provide exposure to a specific industry, such as oil, medicines, or high technology.
• Commodity ETFs: These funds are designed to track the price of a certain commodity, such as gold, oil, or corn.
• Leveraged ETFs: These funds are designed to employ leverage to boost returns.
• Unlike most ETFs: which are designed to track an index, actively managed ETFs are aimed to outperform it.
• Style ETFs: These funds are designed to mirror a specific investment style or market size focus, such as large-cap value or small-cap growth.
• Foreign Market ETFs: These funds are designed to monitor non-Indian markets such as Japan's Nikkei Index or Hong Kong's Hang Seng Index.
• Inverse ETFs: These funds are designed to profit from a drop in the underlying market or index.

ETFs that let the investors’ trade volatility or get exposure to a specific investing strategy - such as currency carry or covered call writing, are examples of alternative investment ETFs.

Benefits of Investing in ETFs

The advantages of ETFs

• Simple to trade - Unlike other mutual funds, which trade at the end of the day, you could buy and sell at any time of day.
• Transparency - The majority of ETFs are required to report their holdings on a daily basis.
• ETFs are more tax efficient than actively managed mutual funds because they generate less capital gain distributions.
• Trading transactions - Since they are traded like stocks, investors can place order types (e.g., limit orders or stop-loss orders) that mutual funds cannot.

Factors to Consider When Choosing ETFs

When selecting ETFs for your investment portfolio, several key factors can significantly impact your returns and overall investment experience. Understanding these elements will help you make more informed decisions aligned with your financial goals. Here are the crucial factors to consider when choosing ETFs:

• Expense ratios: This is the annual fee charged by the ETF to cover operating costs. So, look for ETFs with expense ratios below 0.5%, as these tend to be more cost-effective over time.
• Quality & Risks: Every Asset Class and Investment comes with its own Qualities and Risk factors. It becomes important to select the right ETF suitable to ones requirement depending on the Qualities and Risks that the ETF inherently holds.
• Tracking error: This measures how closely an ETF follows its underlying index. A lower tracking error indicates that the ETF is accurately replicating its index’s performance.
• Liquidity: Higher liquidity means you can buy or sell shares easily without significantly impacting the price. Hence, check the ETF’s average daily trading volume and bid-ask spread (the difference between the highest buy and lowest sell prices).
• Historical performance: While past performance doesn’t guarantee future results, it can provide insights into how the ETF has behaved in different market conditions.

Risks of ETFs

However, there are several disadvantages to using ETFs, which include the following

• Trading costs: If you invest modest sums frequently, dealing directly with a fund company in a no-load fund may be less expensive.
• Illiquidity: Some lightly traded ETFs have huge bid or ask spreads, which means you'll be buying at the spread's high price and selling at the spread's low price.
• While ETFs often mirror their underlying index pretty closely, technical difficulties might cause variances.
• Settlement dates: ETF sales will not be settled for two days after the transaction; this implies that, as the seller, your money from an ETF sale is theoretically unavailable to reinvest for two days.

How to Invest in ETF?

Selecting the Right ETF is not as easy as selecting the Right Clothing! With the many blinds in the investing process, It’s a bit complicated.

To help you simplify the process and help you invest and choose the right ETFs… suitable to your needs and financial goals, get in touch with us at 9820167706 | 9833022706 | 9167696910 or write in to us at customerdelight@sirefafinserv.in

We would be happy to serve you with your needs!

Source / Credits:

• AMFI India
• NSE India
• Appreciate Wealth
• Investopedia

What are Passive Funds?

It is a type of Investment Strategy in Mutual Funds / Stocks that aims to mirror the performance of their underlying benchmark index, such as the Sensex or the Nifty. These funds invest in underlying instruments of the index they track and have fund managers to make sure that the fund constituents replicate the constituents of the index. [1] As of March 2024, passive funds account for about 17% of total MF AUM compared to about 7% five years ago.

Passive Funds / Schemes endeavour to provide returns similar to that of their underlying index, except for some variation due to tracking error which may be because of the expense ratio and other factors concerning the scheme. It should be noted here that an Index is the first barometer we look at to understand how the stock markets have performed. Most of us may not remember the performance of individual stocks over various time periods but it is more likely that we will remember how an index has performed. For e.g. it is easier for most of us to recall what the Nifty 50 Index or Sensex was during March 2020 but the same may not be possible for all individual stocks part of the Nifty 50 Index.

How does Passive Investing work?

Passive investing involves mirroring a market index by holding the same stocks in the same proportions as the index. For instance, a Nifty 50 index fund will include the same companies as the Nifty 50 index. The objective is to match the market’s performance rather than outperform it, so when the market rises or falls, your investment does the same.

In the case of commodities, such as gold, a gold ETF invests in physical gold bars with 99.5% purity, tracking the price of gold directly. Since passive funds simply follow the market, they require minimal management, which keeps costs lower than actively managed funds.

In summary, passive funds can provide a simple, low-cost way to invest by mirroring the market, making them an easy-to-understand option for many investors seeking a straightforward approach.

Types of Passive Funds

As India’s financial landscape evolves, passive mutual funds continue to attract both novice and seasoned investors. These funds come in several forms, each with distinct features and goals.

Index Funds

Index funds are designed to mirror the performance of a specific market index. They build their portfolios by investing in the same securities and proportions as the chosen index. Rather than trying to outperform the market, index funds aim to match the benchmark’s performance, offering a straightforward way for passive investors to gain broad market or sector exposure.

Fund of Funds (FoFs)

A Fund of Funds (FoF) is a unique passive investment vehicle that invests in multiple mutual funds rather than individual securities. By pooling funds from various sources, an FoF achieves diversification across different asset classes, sectors, and markets. The fund manager selects and manages passive funds that suit the investor’s risk profile, which can come from the same or different fund houses. FoFs offer an efficient way to diversify portfolios and manage risk.

ETFs (Exchange-Traded Funds)

ETFs are a popular type of passive fund, merging the benefits of stocks and mutual funds. Traded on stock exchanges, ETFs offer investors exposure to a range of assets, such as equities, bonds, and commodities, by tracking an underlying index. Like stocks, they can be bought and sold throughout the trading day, providing flexibility and liquidity. Investing in ETFs requires a Demat account for transactions.

Smart Beta Funds

Smart Beta funds combine elements of both active and passive mutual funds management. Using a rules-based strategy, these funds consider factors like value, quality, or momentum to create portfolios that differ from traditional market-cap-weighted indexes. The goal is to achieve better risk-adjusted returns than the benchmark while maintaining the cost-efficiency typical of passive investing.

Advantages of Passive Mutual Fund schemes:

Lower in cost:

ETFs and index funds have a lower expense ratio as compared to any active mutual fund scheme. The primary reason is that the portfolio is simply replicated from the chosen market index. 

Reduced dependency on the fund manager to actively pick securities:

Although fund managers of actively managed schemes make investment decisions on the basis of analysis, research and forecasts etc which are likely to return more than the benchmark index, sometimes this approach may not yield higher returns than the benchmark. Since an index fund replicates the market index, say Sensex, there is a reduced risk of such instances and the returns will be almost similar to the returns of the Index subject to the tracking error.

Exposure to the broad market:

Broad market Indices are diversified and represent the broader stock market. So, if you invest in a passive fund that tracks a broad market index, it will give you exposure to a vast range of stocks that may represent the market movement.

Easily understandable:

Since these funds closely replicate their underlying benchmarks, you can expect a return that is close to that of your fund's underlying benchmark subject to tracking error.

Disadvantages associated with investing in passive fund schemes:

Does not focus on outperforming the market:

There is no focus on earning higher returns than the benchmark index. Since the fund manager is bound to replicate the portfolio of the underlying benchmark index in the case of an index fund or an ETF, the investors may not get the possibility of earning higher returns than the underlying benchmark index. 

Less flexibility:

The fund manager does not actively choose the instruments that have to be part of the underlying portfolio since the fund manager does not have the option to choose the securities that are not part of the underlying index.

Tracking error:

Tracking error is a very important factor when it comes to passive funds. These errors signify how closely a fund is tracking its underlying benchmark index. The higher the error, the greater the deviation between the fund’s performance and the performance of its underlying benchmark index. 

How to Invest in Passive Funds?

Selecting the Right Passive Funds is not as easy as selecting the Right pair of Shoe! With the many blinds in the investing process, it’s a bit complicated.

To help you simplify the process and help you invest and choose the right Passive Funds... suitable to your needs and financial goals, get in touch with us at 9820167706 | 9833022706 | 9167696910 or write in to us at customerdelight@sirefafinserv.in

We would be happy to serve you with your needs!

Source / Credits:

• SmallCase
• Investopedia
• Zerodha Fund House