What is an ETF? How it works?

An ETF is a fund, just like a mutual fund which owns assets like stocks, bonds, gold etc, divides its ownership in shares which are held by the shareholders.

So are ETFs and mutual funds same? If you look at their structure, both are similar, but there is a major difference between them.

Unlike mutual funds, ETF can be bought or sold in a stock exchange just like a normal stock. This provides liquidity to investors, and an opportunity to trade in index, taking advantage of market fluctuations in the short term.

Secondly, being a low cost investment, ETFs are usually preferred by short term investors who want to park their money in a place for short term and want small profits, without paying a high commission.

Why were ETFs needed?

For many years, success of a fund was measured by comparing its performance against benchmark index. Wider the difference, better the fund. The method, which may seem logical had its own flaws:

Firstly, There were very few funds that could beat the index, most of the funds struggled to keep pace with the benchmark and hardly ever achieved the desired result.

Secondly, Past performance does not guarantee future results, even if a fund managed to outperform its benchmark, it was no guarantee that it will be able to maintain similar performance in the future.

Finally, Many funds, in desperation to beat the index, behaved irrationally and sold quality stocks with growth potential just because they were temporarily not performing. This behavior caused a great harm as many funds sold future multibagger stocks for a short term profit.

The purpose of ETF:

The purpose of Exchange Traded Fund is not to beat the index but to mimic its movements. This was preferred by the investors as there was no desperation to beat something or someone, the idea was to simply move with the benchmark. So how does it manage to mimic the market.The answer lies in one word “Arbitrage”

Arbitrage is a method where investors take advantage of price difference of a stock in different exchanges and use this difference to make profit. For example, If a stock is trading at Rs. 100 in BSE and Rs.102 in NSE, the investor will buy the stock in BSE and sell it in NSE, taking a profit of Rs. 2 per share (Sell price-Buy price=Profit): (102-100=2).

How ETFs work?

ETFs are managed by large market players, such as institutional investors known as Authorized Participants (AP). These APs obtain the underlying securities (assets which together compose an ETF) and and places them in the fund, which are known as creation units. In exchange of this, they get a fraction of total ownership of the fund.

Just like markets are imperfect and do not trade at the exact value of the underlying securities, similarly, the value of ETF and the overall value of the underlying assets differ at some point of time. This difference creates an arbitrage opportunity for the investors to profit by selling either the ETF or the underlying security and buying the other. To understand in a better way, let’s take a small example.

Let’s say, the total value of the underlying asset per share is Rs. 100, and the value of one share of ETF is also Rs. 100. For some reason, demand for ETF picks up and one share of ETF is now trading at Rs. 105, while the total underlying value of the assets per share is at Rs.102. This presents an arbitrage opportunity for APs. The APs then buy the underlying shares (for Rs. 102) and sell the ETF (for Rs. 105), giving them a profit of Rs. 3 per share(105-102=3 per share). Since shares are bought and sold in large quantities, an additional supply of shares brings down the price of ETF, eliminating the price difference between ETF and underlying asset. Similar process applies when the demand for ETF is low but the value of underlying asset per share is high.

Types of ETFs:

ETFs are not just limited to some indices, there is a good variety of ETFs’ that replicate various kind of assets classes and assets. Some of the most common types of ETFs are as follows:

Index ETF:

Most ETFs are index ETFs that replicate the movement of the underlying index. While most ETFs hold the same assets as the underlying index, some ETFs use representative sampling, that is they hold assets 90% similar to the underlying index and rest 10% is invested in asset like futures and options which according to fund advisors helps ETF to achieve its objective.

Sector ETF:

Sector ETF track specific sector or industry index such as Bank Nifty, Nifty Auto Index, etc. These ETFs, instead of replicating a broad index, follow a sector or industry specific indices. Investors looking to invest in thematic mutual funds can also invest in these ETFs as an alternate.

Bond ETF:

As the name suggests, these ETFs; invest in bonds, such as government bonds, corporate bonds etc. These funds usually thrive during recessions as they are seen as safe havens during market crash. These are not very high yielding ETFs but can be used as parking place for your cash if it is not going to be invested for sometime.

Commodity ETF:

Commodity ETFs invest in various commodities such as precious metals (Gold, Silver, Platinum etc.). There are some commodity indices that track agri commodities and Oil. Commodity ETFs are great investment if one wants to buy precious metals and hold it for long term. One of the most popular commodity ETF is Gold ETF.

Which one is better for you ETF or Mutual Fund?

As mentioned earlier, both Mutual Funds and ETFs are similar in structure but what may influence an investor’s preference is how differently they behave.

Mutual funds are generally preferred by investors who want to invest small amounts of money on a regular basis, just like an SIP. On the other hand, ETFs are preferred by those who have a lump sum money to invest (such as a retirement fund received)and want to take advantage of higher returns offered by the market while minimizing the risk at the same time.

In short, both ETF and mutual funds are great investments, but which one should you prefer totally depends on your personal needs and financial goals. ETF is an instrument about which very little is known to average investor. With right financial education and spreading awareness, ETFs will gain popularity over time.