Chapter 12 : Exchange Traded Funds: Part 2

Equity Exchange Traded Funds

Equity Exchange Traded Funds (ETFs) are investment products that are a combination of stock investments and equity mutual funds. Basically, they follow a specific stock index like NIFTY50, SENSEX, etc.

Unlike mutual funds, these ETFs can be traded on stock exchanges. They are passively managed, held in demat form and have a much lower expense ratio than equity mutual funds.

Index ETFs

An index ETF tries to mimic or emulate the returns of an index. They invest directly in the stocks listed on an index in the same proportion. For instance, an NSE Nifty 50 Index ETF will invest in equities of all the 50 companies listed on the index in the same weightage as they are in the index. This way, they can get returns close to the index.

However, index ETF returns are not always exactly the same as the tracking index. Returns are slightly lower since the returns also take into account fund expenses like management fees, expense ratio, etc. If you remember, the difference in returns that an index fund generates from the returns of its underlying index is known as the tracking error. The lower the tracking error, the better performing the ETF.

• Index ETFs may also invest a small portion of funds in money market instruments for the sake of liquidity.
• Index ETF returns are rather predictable because of the underlying index that they follow.

Benchmark Indices

A benchmark is a select group of securities which are considered to be a 'benchmark' or set the standard to measure a stock’s or a fund’s performance. An Index ETF is explicitly designed to replicate its underlying benchmark index. India has two major benchmark indices: SENSEX and NIFTY50.

• The NIFTY 50 is a benchmark index of the weighted average of the 50 largest Indian companies listed on the NSE.
• The SENSEX is a benchmark index that comprises of the 30 largest and most actively-traded stocks on BSE.

Sector ETFs

A sectoral exchange-traded fund is an ETF that invests specifically in the equity securities of a particular industry or sector. The sector is usually mentioned in the fund’s name itself. For instance, an energy ETF may invest only in energy stocks, while a technology ETF will invest in securities in the tech industry. 

Global ETFs

Global ETFs are investment products that allow investors in India to take exposure to international indexes like NASDAQ100 and HangSeng. These funds trade on the cash market of NSE just like any other company stock. 

Difference Between Active and Passive investing

Since Index ETFs seek to track and replicate the underlying benchmark index, it is considered to be one of the most common forms of passive investing. Let’s look at how passive investing is different from active investing.

Debt ETFs

Debt ETFs combine debt security investments with the advantages of trading on stock exchanges. They invest in different fixed income securities depending on an underlying fixed income index like Nifty 8-13 years G-Sec Index or NIFTY 4-8 years G-Sec Index

Like all other ETFs, these are also passively managed funds. Due to the same portfolio, these funds also offer returns similar to the underlying index.  The expense ratio is lower as compared to mutual funds.

Summary

• Equity Exchange Traded Funds (ETFs) are investment products that are a combination of stock investments and equity mutual funds.
• ETFs can be traded on stock exchanges. They are passively-managed, held in demat form and have a much lower expense ratio than equity mutual funds.
• The most popular types of ETFs in India are:
  • Equity ETFs invest according to a specific stock index.
  • Debt ETFs invest according to a specific debt index.
  • Gold ETFs invest in gold.
  • Global Index ETFs allow investing in global indexes.
  • An index fund tries to mimic or emulate the returns of an index.
  • The difference in returns that an index fund generates from the returns of its underlying index is known as the tracking error.
  • A benchmark is a select group of securities which are considered to be a 'benchmark' or set the standard to measure a stock’s or a fund’s performance.
  • Active investment strategy is a hands-on approach where a fund manager personally studies the market and decides which securities to invest in.
  • Passive investing is about investing in a pre-defined list of securities that provide returns, as in the case of index ETFs.

That’s the end of the overview on ETFs. The next chapter will cover more mutual fund schemes that you need to be aware of.