What is an Exchange Traded Fund (ETF)
Exchange traded funds (ETFs) are a very popular form of passive investing. In this article we take a look at the nuances of an ETF.
Exchange traded funds (ETFs) are a very popular form of passive investing. When we talk of passive investing, we refer to the opposite of active investing. In active investing, you take a view on a stock and then create a portfolio or you invest in a mutual fund where the fund manager takes a view on the market and stocks. In an ETF you just decide the asset you want to invest in like; equity index, bond index, gold, international equity etc. You just buy the ETF and let the passive investment do the rest. Let us look at the nuances of an ETF.
An ETF is a closed-ended mutual fund structure
An ETF is essentially a closed ended fund which raises money like an IPO. Retail investors cannot go to the fund and buy units. One can only buy the ETF units from the stock market subject to liquidity. That means you can buy or sell only if there is a counter party available. Of course, most ETFs do have market makers but there is no obligation on the part of the ETF to give you sale and repurchase around the NAV value.
What is the underlying for an ETF?
You can have ETF on a variety of different asset classes. The most popular in India are index ETFs and gold ETFs. In case of index ETFs, the fund will hold equivalent shares of the index in the same proportion as their underlying portfolio. In case of gold ETFs, the equivalent amount of gold is held with the custodian in physical form. Normally, for most gold ETFs in India, the Bank of Nova Scotia is the custodian of physical gold. Globally, ETFs offer a lot more choice. There are ETFs on equity indices, debt market indices, gold, silver, international indices, international asset classes, emerging markets etc. So in case you are holding gold ETFs, you do not have to worry about what happens to your money. Your gold ETF investment is fully backed by actual gold sitting in the custody of the Bank of Nova Scotia. Yes, you still have the price risk, which is all!
ETFs are listed and traded on the stock exchange
When an ETF issues units the per-unit quantity is determined in advance. For example, in case of the Reliance Gold ETF, the single unit consists of 1 gram of gold. So if the market price of gold in India has a reference rate of Rs.29,000/10 grams, then one unit of the ETF will quote at around Rs.2900/- unit, adjusted for costs. These units will have real time quotes unlike regular open ended mutual funds which only have end-of-day NAVs. When an investor buys or sells ETF units, the brokerage is payable on these units. Like in the case of shares, the delivery of the ETF also comes into your demat account on T+2 day and when you sell the ETF units, the credit into your bank account will also come in T+2 days. You do not require a separate demat account but you can hold the ETF units in your regular demat account itself.
No impact on the AUM by buying and selling of ETF units
What happens when you buy units of a mutual fund? The AMC issues fresh units and the AUM increases to that extent. Similarly, when you redeem units, the outstanding units of the fund reduces and the AUM also reduces proportionately. In case of ETFs, the core AUM does not change. When you buy an ETF, there is another investor who is looking to sell the ETFs. Therefore it is exactly like secondary market trading of shares which does not have any impact on the share capital except changing the owners of the shares. Normally, ETFs tend to be fairly liquid and it is possible to buy and sell ETFs in the market freely without too much of an impact cost.
Most ETFs do accept direct investments provided it is above certain threshold. For example, if you are holding index ETFS worth more than say, Rs. 1 crore and want to redeem the same then you may not find necessary buyers in the market. In that case, you have the option of directly approaching the fund to buyback your units and there is a provision for the same.
ETFs are emerging as a veritable investment option in India. Of course, a lot will still depend on how passive investing picks up in India in the coming years.