An exchange-traded fund is an investment fund that replicates the price fluctuations of an underlying asset, and is traded on the stock exchange just like a stock.It tracks the performance of the security or asset that the investor originally wishes to invest in Thus, the ETF will move in the same way as the underlying security it is designed to follow. In India, most ETFs are index funds based on the NIFTY or SENSEX, or gold ETFs, which track the value of gold commodity.

How ETFs work:

Let’s say a fund creates an ETF to track the performance of gold. This proposal is approved by the SEBI, and equivalent units of gold are stored with the custodial bank. Let’s say that the value of one unit of ETF is held equivalent to the value of 1 gram of gold. Now the fund can sell these gold ETFs to investors in the market by listing it on the stock exchange. Technically, if an investor buys 10 units of ETF, 10 grams of gold are transferred in his name. The investor can redeem the units by converting the ETFs to gold if he wishes to, and sell it. However, it is much easier to sell the ETFs directly on the exchange, as they are of the same value. There would be no difference in the price of the ETF and the value of gold, because in case of any discrepancy in value, investors can exploit the ETF arbitrage and gain profits from buying in one form and selling in the other.

The creation/redemption process of ETF

The crux of how the ETF works is in understanding the in-house creation/redemption process of ETF. The creation/redemption mechanism allows the fund toadjust the quantity of ETF shares based on demand without impacting other investors of the fund. This flexible process is done by an authorized participant (AP). The investor, therefore, never makes the decision to create or redeem; that is simply a back-office function that is determined by the broker.

The AP, who generally is an institution with a lot of buying power, has to acquire the securities that the ETF wants to hold. For instance, if an ETF is designed to track the NIFTY, the AP will buy all the NIFTY shares in the exact same proportion as the index and deliver them to the ETF issuer. In exchange for the shares, the issuer gives the AP a block of equivalent ETF units.This is in blocks of 50,000 units, called as ‘one creation unit’.

This exchange takes place on a fair-value basis, where the AP delivers the underlying shares and receives the exact same value in ETF units. The price of ETF units is based on their net asset value (NAV), not the market value at which the ETF is trading at that time. Thus, both parties benefit from the transaction. The issuer gets the stocks it needs to track the index, and the AP gets plenty of ETF shares to resell for profit.

Inversely, the AP can remove ETF units from the market by purchasing enough units to form one creation unit and then giving the units to the issuer. In exchange, the fund provides the AP with the underlying securities at their fair value.

ETFs all over the world:

The concept of ETF has gained increasing popularity and opened up a panorama of investment opportunities.One can now invest in a wide range of conventional and unconventional securities, stocks and even commodities which were not physically possible to invest in before. Underlying Assets of the most popular ETFs across the world include,

• Gold
• Emerging markets index funds
• S&P 500
• Brazil index
• Corporate bond fund
• Silver
• FTSE China 25

There are many types of ETFs trading all over the world.

1. Index ETFs

These replicate the performance of an index. The index could be of stocks, bonds, commodities or currencies.

 

2. Stock ETFs:

Stock ETFs track a selection of stocks or stock indices. They can be based on large cap, mid cap, or small cap stocks, growth stocks, value stocks, sector funds, etc. One can invest in indices of other countries and markets via stock ETFs.

 

3. Bond ETFs:

These are ETFs that track the bond yields, and do particularly well when other markets like stocks under perform.

4. Commodity ETFs:

Commodity ETFs track commodity prices like precious metals, agricultural products, energy, etc. Gold and silver are favourites among commodity ETFs because they have a hedging function along with the prospects of price increase.

5. Currency ETFs

The first currency ETF was launched in 2005 tracking EURO, soon after which all major currencies started being tracked on Foreign Exchange Platforms. Currency ETFs are actively traded by institutional investors to hedge risks as well as to speculate.

6. Inverse ETFs:

These ETFs are typically designed using short positions to benefit from a falling market. Inverse ETFs are usually based on future contracts as the underlying asset.

7. Leveraged ETFs:

These ETFs use leveraging options to provide returns which are 2x, 3x, 4x times the returns on the underlying asset.

 

ETFs in India

The market for ETFs in India, even though not as vibrant and extensive as in the western countries, is still widely diversified. Due to the many advantages that it offers over mutual funds and other investment vehicles, ETF has become a preferred product among many investors. The ETFs in India are classified under 4 main types

1. Equity ETFs: These include equity index funds like NIFTY & SENSEX, NIFTY BEES, CNX 100, Sectoral ETFs like Banking, Infra, etc.
2. Gold ETFs
3. World Indices ETFs: Currently NASDAQ ETF is available.
4. Debt ETFs: These include Fixed Income securities like Government Securities (G-Sec) ETFs and Gilt ETFs.
5. Liquid ETFs: These are money market ETFs which invest in a basket of short term and medium term securities. Liquid BeES which was launched by benchmark mutual fund is the first money market ETF in the world.

Even though there are many ETFs available in the Indian markets, it is still at the nascent stage, and there are many sectors where ETFs are largely in demand. For example, silver is a highly traded commodity in the Indian Commodities Market, but there is not a single Silver ETF listed on Indian Exchanges. ETFs like Oil and Gas, hydrocarbons, currencies, emerging markets indices, which are highly traded in foreign markets are still lacking in India. ETFs can open up new doors for educated Indian investors with a reasonable investment appetite.

Advantages of ETFs

There are many advantages of investing in ETFs

• They can be easily bought or sold on the exchange at any time during the market hours, just like a stock.
• They have the advantage of both equity and mutual funds, in that they can be traded like stocks, but offer diversification like mutual funds (in case of index funds).
• They are passively managed and do not require an investment strategy. Hence, they have a low expense ratio than a fund.
• ETFs can be good hedging instruments as they provide arbitrage between cash market and futures market.
• ETFs are open to all investors, be it large institutional players or retail investors.
• The minimum amount that can be invested is just one unit.

 

FAQs

1. What is the tax treatment of ETFs?

 

For Gold ETFs, holding period less than 3 years attracts a Short-Term Capital Gain (STCG) tax, which is as per the investors income tax slab rate. Long-term Capital Gains (LTCG) tax is applicable for a period of more than 3 years, and is 10% without indexation, and 20% with indexation.

2. Which is better, physical gold or Gold ETFs?

In India, gold is bought majorly for jewellery, to mark auspicious occasions, and for savings and investment. ETFs cannot replace physical gold for ornamental purposes, but it has various advantages over physical gold for the purpose of investment and saving.

• No need for storage: Since ETFs are stored in demat form, there is no concern about its storage, unlike physical gold, which needs to be kept securely in a safe or a bank locker. Thus the storage cost of ETF gold becomes NIL, and is completely safe. In case of paper ETFs also, the redemption is possible only by the investor, and hence theft of ETF certificates does not result in loss of ETF gold, which can be retrieved by following the procedure for stolen document.
• Ease of trade: It is much easier to buy and sell gold ETFs rather than physical gold. This is because the market for gold ETFs is highly liquid due to exchanges. Also, in case of physical gold, any jeweller or merchant may sell you the gold, but all may not buy it back at the fair price that you deserve. However, there are no chances of being cheated or manipulated in ETF gold due to standardization of quality and strict guidelines by Securities and Exchange Board of India (SEBI) to protect the investors.
• Standardization: In case of physical gold, which is mainly used for jewellery, one has to be sure of its purity before buying. Since pure 24 karat gold is extremely soft, it cannot be used for jewellery; hence 22 karat gold is generally used. Even so, the average investor cannot always be sure of the purity of this ornamental gold, unless he gets it verified from a trusted source. However, in case of gold ETFs, the underlying gold is tested an verified for purity, while the ETF itself is just an ownership proof in the form of paper or demat, and does not require quality verification.
• Making charges are NIL: In case of buying jewellery or even gold coins/bars, there are making charges involved. These are much higher than the expense ratio of ETFs. Hence, for investment purpose, ETFs are a better option.

 

3. How is an index ETF different from an Index Fund?

 

• The primary difference between the two is that the working of an Index Fund is like a mutual funds, in that the price of a unit, or the NAV, is determined at the end of the trading day, whereas ETFs are continuously changing their price throughout the day, just like a stock. Thus, ETFs are more liquid.
• Since ETFs are listed on the stock exchange you need a demat account to trade in them, whereas for an Index Fund, you can buy or sell its units directly from the mutual fund.

 

 

4. How is ETF different from a futures contract of the same underlying asset (gold or index)?

Even though ETFs and Futures Contracts are both deriving value from an underlying asset, there are many marked differences between the two.

• The ticket size of an ETF is much smaller than a futures contract, making it easier for even retail investors to invest in.
• Leveraging is not possible in ETFs in India, while futures contract allow leverage which can multiply the investors’ profits as well as loss/
• Trading in futures contract is high maintenance, as it requires having access to a derivatives terminal which must be opened with a broker, and one has to adhere to the margin requirements mandated by the exchange. While ETFs require only a demat account.
• Futures contracts have a higher trading cost as they have to be rolled over every 3 months, while ETFs are passively managed and can be held for any amount of time. Hence ETFs are much cheaper to invest in.

 

5. Who should invest in ETFs?

ETFs are available for everyone to invest in. They are particularly useful for the following classes of people

• Retail investors: Retail investors looking at a long-term horizon can consider Index ETFs as it diversifies the portfolio with even a small investment. Also due to the creation/redemption process, short term trading activity of large investors will not affect the ETF prices and protects the retail investors from market shocks.
• Foreign Institutional Investors, Financial Institutions, Mutual Funds: ETFs are good hedging instruments for such large players. They also provide diversification and an avenue to park liquid funds.
• Arbitrage Funds: ETFs are low cost and hence provide easy and cheaper arbitrage between cash and futures market.