One of the different types of mutual funds, exchange-traded funds or ETFs are known for being similar to index funds in some ways. That’s because just like in the case of index funds, ETFs are also known for tracking an underlying index. They are known for being passive investment instruments. Meaning, that the fund invests in the constituents of the underlying index. In simple words, an ETF can be described as a basket consisting of securities that are known for usually matching an Index’s composition, thereby keeping the proportion similar to the underlying index. As ETFs are known for just tracking an index’s performance, there is no requirement for active management by the fund manager with them. Also, ETFs do not attempt to outperform their indices either.
How do exchange-traded funds work?
An ETF is a type of mutual fund that’s listed and traded on the stock exchange. It can be bought and sold through exchange just you do it with stocks. While the majority of ETFs are passively managed, there are some ETFs that are actively managed as well. A passive ETF is built in such a way that it can track an index such as the NIFTY 50, which is known for investing in the companies listed under the NIFTY 50 in the same proportion. Furthermore, ETFs may also track an index that represents a sector (like NIFTY Pharma), or a commodity like gold, which is known for tracking the physical gold price. Furthermore, ETFs are also known for having symbols just like every company’s share can be identified by a specific symbol. For instance, on the exchange, the IT company Infosys is listed with the symbol INFY. So, while looking for the share price of Infosys, all you need to do is perform the search as ‘INFY’. Correspondingly, every ETF comes with a specific ticker symbol as an identifier. By looking for this symbol, you can determine the ETF and find its current price. But it is important to note that there are different types of ETFs that are available in the market as investment options. Those variants of exchange-traded funds are:
- Equity ETFs:
These ETFs are known for tracking a broad market stock index such as the BSE SENSEX or NIFTY 50. Also, there are some International ETFs which are known for tracking the popular index of an international market such as NASDAQ 100 or Hang Seng. Equity ETFs enable investors to take the first step in equity investing by providing them with a flavour of what it feels like in investing in stock markets. By Opting for such an ETF, you also get a chance to own all stocks in a popular index and help their portfolio post near index-matching returns (depending on things like expense ratio and tracking errors).
- Fixed Income ETFs:
Fixed income ETFs are known for replicating the performance of an underlying bond index that consists of securities like G-secs, bonds of government companies, state development loans (SDLs), money market instruments and many more. These ETFs can help in reducing a portfolio’s volatility by opting to diversify ETF investments into the securities mentioned above. Currently, in India, you can buy liquid ETFs, ETFs allocating funds to public sector companies’ debt issues, and government bond ETFs.
- Debt ETFs:
Debt ETFs are known for exposing investors to debt securities such as corporate bonds, commercial papers, government securities and many more. These ETFs are known for tracking a debt index which, at times is designed for the ETFs specifically. Consider Edelweiss Bharat Bond as an example. This ETF only tracks the NIFTY BHARAT Bond Index. The index is known for representing the bonds issued by specific public sector companies.
What are the terms you should be aware of before opting for ETFs?
An ETF investor should be aware of the two terms mentioned below:
- Tracking error:
A tracking error can be defined as the difference in the performance of the ETF in comparison to the index it tracks. A tracking error might be a result of multiple things like a delay in the purchase or sale of securities, ETF holdings in cash/cash equivalents, and expenses of the scheme. Regardless of the reason, the ETF cannot mimic the Index’s returns entirely. The higher the tracking error, the higher will be the difference in the fund’s performance in comparison to its index. Therefore, it makes sense to choose an ETF with a lower chance of tracking error and monitor the tracking error.
- Net asset value (NAV):
As ETFs are known for having the features of both, a mutual fund scheme and stock, it is important for you to understand both, net asset value, i.e., NAV and the market price of these funds. The value of an ETF’s underlying asset can be defined as the net asset value (NAV). And the price at which units are bought and sold on an exchange is referred to as the market price of the ETF.