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. 

Did you know?

  • India got its first ETF in 2001 – the Nifty Benchmark Exchange-Traded Scheme (Nifty BeES), listed on the National Stock Exchange, tracking the Nifty 50 Index.
  • In 2004, the first debt ETF came into being – the Liquid BeES.
  • In 2007, the AMC introduced Gold BeES, the first gold ETF in India.

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.

Active Investment Strategy

Passive Investment Strategy

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, as in the case of index ETFs.

Active investing aims to generate higher returns than the market average.  

Passive investment strategies aim to meet market returns.

Costs are higher since they require active research, frequent buy and sell decisions and other operational expenses.

Costs are lower compared to an active strategy because it does not have high research and management costs. However, basic operational expenses still exist, which can lead to a tracking error.

Active investment returns depend upon the fund manager’s investment strategy.

Passive returns are dependent on the underlying asset or index’s performance.

Risks and returns depend upon the securities the fund manager chooses to invest in.

Risks are lower because you get more or less same returns depending upon the underlying’s performance.

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.

Disclaimer:

ICICI Securities Ltd.( I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Centre, H. T. Parekh Marg, Churchgate, Mumbai - 400020, India, Tel No : 022 - 2288 2460, 022 - 2288 2470. AMFI Regn. No.: ARN-0845. We are distributors for Mutual funds. Mutual Fund Investments are subject to market risks, read all scheme related documents carefully. The contents herein above shall not be considered as an invitation or persuasion to trade or invest.  I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. The contents herein mentioned are solely for informational and educational purpose.