Understanding ETFs
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An ETF is a basket of securities that is traded on the stock exchange, just like
a stock. So, ETFs are listed on a recognised stock exchange. Their units can be
bought and sold directly on the exchange, through a stockbroker during the trading
hours. ETFs can be either close-ended or open-ended. Open-ended ETFs can issue fresh
units to investors even post the new fund offer stage.ETFs can be either actively
or passively managed. In an actively-managed ETF, the objective is to outperform
the benchmark index. On the contrary, a passively-managed ETF attempts to replicate
the performance of a designated benchmark index. Hence it invests in the same stocks,
which comprise its benchmark index and in the same weightage. For example, Nifty
BeES is a passively managed ETF with the S&P CNX Nifty being its designated benchmark
index.
When you buy or sell a stock, you are basing your transaction on the predicted performance
of one company. When you buy or sell an ETF, you are basing your transaction on
the predicted performance of multiple companies.When you buy or sell an index, you
are actually buying shares in individual companies. With an ETF, you are buying
shares in a portfolio of those companies. So, if you had an opinion about a certain
company in the index basket, you could make an adjustment by selling or buying shares
of an individual equity (although, this is not common). With an ETF, you cannot
adjust the individual equities in the portfolio.
ETF units are continuously created and redeemed based on investor demand. Investors
may use ETFs for investment, trading or arbitrage. The price of the ETF tracks the
value of the underlying index. This provides an opportunity to investors to compare
the value of underlying index against the price of the ETF units prevailing on the
stock exchange. If the value of the underlying index is higher than the price of
the ETF, the investors may redeem the units to the asset management company that
sponsors the ETF in exchange for the higher priced securities. Conversely, if the
price of the underlying securities is lower than the ETF, the investors may create
ETF units by depositing the lower-priced securities. This arbitrage mechanism eliminates
the problem associated with closed-end mutual funds viz. the premium or discount
to the NAV.
ETFs are not MFs
You may get confused between ETFs and conventional mutual funds. However, they are
different on several counts. The only similarity between ETFs and conventional mutual
funds is that they both provide you an opportunity to invest in a variety of stocks/instruments
through a single instrument.
When you invest in a mutual fund, you need to buy and sell units from the fund house.
Since buying and selling of ETFs is done on the stock exchange, the transaction
has to be routed through a broker. If ever you can buy or redeem units in an ETF
through the fund house, it is normally done in a pre-defined lot size. Typically,
the lot size tends to be substantial making it feasible only for institutional investors
and high networth individuals.
Since ETFs are traded on the stock exchange, they can be bought and sold at any
time during market hours like a stock. This is known as ‘real time pricing’. In
contrast, mutual funds can be bought and redeemed only at the relevant NAV; the
NAV is declared only once at the end of the day. As a result, you have the opportunity
to make the most of intra-day volatility in case of ETFs. This may not hold much
significance if you are a long-term investor.
Mutual funds are always available at end-of-day NAV, whereas ETFs do not necessarily
trade at the NAV of their underlying portfolio. In fact, the market price of an
ETF is determined by the demand and supply of its units, which in turn is driven
by the value of its underlying portfolio. But in case of a close-ended ETF the price
remains fixed. Therefore, the possibility of an ETF trading below (at a discount)
or above (at a premium) its NAV does exist.
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