ETFs are just what their name implies: baskets of securities that are traded, like individual stocks, on an exchange. Unlike regular open-end mutual funds, ETFs can be bought and sold throughout the trading day like any stock.
Most ETFs charge lower annual expenses than index mutual funds. However, as with stocks, one must pay a brokerage to buy and sell ETF units, which can be a significant drawback for those who trade frequently or invest regular sums of money.
They first came into existence in the USA in 1993. It took several years for them to attract public interest. But once they did, the volumes took off with a vengeance. Over the last few years more than $120 billion (as on June 2002) is invested in about 230 ETFs. About 60% of trading volumes on the American Stock Exchange are from ETFs. The most popular ETFs are QQQs (Cubes) based on the Nasdaq-100 Index, SPDRs (Spiders) based on the S&P 500 Index, iSHARES based on MSCI Indices and TRAHK (Tracks) based on the Hang Seng Index. The average daily trading volume in QQQ is around 89 million shares.
Their passive nature is a necessity: the funds rely on an arbitrage mechanism to keep the prices at which they trade roughly in line with the net asset values of their underlying portfolios. For the mechanism to work, potential arbitragers need to have full, timely knowledge of a fund’s holdings.
In essence, ETFs trade like stocks and therefore offer a degree of flexibility unavailable with traditional mutual funds. Specifically, investors can trade ETFs throughout the trading day as in stocks. In comparison, in a traditional mutual fund, investors can purchase units only at the fund’s NAV, which is published at the end of each trading day. In fact, investors cannot purchase ETFs at the closing NAV. This difference gives rise to an important advantage of ETFs over traditional funds: ETFs are immediately tradable and consequently, the risk of price differential between the time of investment and time of trade is substantially less in the case of ETFs.
ETFs are cheaper than traditional mutual funds and index funds in terms of fees. However, while investing in an ETF, an investor pays a commission to the broker. The tracking error of ETFs is generally lower than traditional index funds due to the “in-kind” creation / redemption facility and the low expense ratio. This “in-kind” creation / redemption facility ensures that long-term investors do not suffer at the cost of short-term investor activity.
ETFs can be bought / sold through trading terminals anywhere across the country. Table No. 1 presents a comparative view ETFs vis-à-vis other funds.
ETFs Vs. Open Ended Funds Vs. Close Ended Funds
Parameter Open Ended Fund Closed Ended Fund Exchange Traded Fund
Fund Size Flexible Fixed Flexible
NAV Daily Daily Real Time
Liquidity ProviderFund itself Stock Market Stock Market / Fund itself
Sale Price At NAV plus load, Significant Premium Very close to actual NAV of Scheme
if any / Discount to NAV
Availability Fund itself Through Exchange where listedThrough Exchange where listed / Fund
Portfolio Disclosure Monthly Monthly Daily/Real-time
Uses Equitising cash – Equitising Cash, Hedging, Arbitrage
Intra-Day Trading Not possible Expensive Possible at low cost
Applications of ETFs
* Efficient Trading : ETFs provide investors a convenient way to gain market exposure viz. an index that trades like a stock. In comparison to a stock, an investment in an ETF index product provides a diversified exposure to the market. Depending on the index, investors may obtain exposure to countries/ markets or sectors.
* Equitising Cash : Investors with idle cash in their portfolios may want to invest in a product tied to a market benchmark like an index as a temporary investment before deciding which stocks to buy or waiting for the right price.
* Managing Cash Flows : Investment managers who see regular inflows and outflows may use ETFs because of their liquidity and their ability to represent the market.
* Diversifying Exposure : If an investor is not sure about which particular stock to buy but likes the overall sector, investing in shares tied to an index or basket of stocks provides diversified exposure and reduces stock specific risk.
* Filling Gaps : ETFs tied to a sector or industry may be used to gain exposure to new and important sectors. Such strategies may also be used to reduce an overweight or increase an underweight sector.
* Shorting or Hedging : Investors who have a negative view on a market segment or specific sector may want to establish a short position to capitalize on that view. ETFs may be sold short against long stock holdings as a hedge against a decline in the market or specific sector.