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ETFs 101 – What is an ETF?

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With the recent underperformance of most active mutual funds in 2018, there has been an increasing focus on passive investing & especially indexing. Exchange Traded Funds (ETFs) have suddenly become very popular, receiving a lot of media attention and interest from investors – yet most of us don’t really know what exactly are ETFs & how they function.

As a result, many facts have mingled with rumours (e.g. ETFs aren’t liquid), making it challenging for even informed investors to really understand & invest in them. But while ETFs are a new concept in Indian markets, they’ve actually been around for a long time – since 1990s. They have even become the preferred investment choice of most retail investors across the world.

We’re starting a series of 5 posts on ETF Education that will cover – what are ETFs & how they differ from mutual funds, the origin and history of ETFs, how ETFs function & liquidity is created, what makes the structure inherently better for long-term & buy-and-hold investors. We kickstart this series with this first post on ETF Basics.

A Brief History of Exchange Traded Funds

The modern-day open-ended mutual fund structure is a financial innovation from the early 1920s. Rather than buying single stocks, investors now had the option to invest in a diversified portfolio managed by an investment professional.

The next major innovation happened with the creation of Exchange Traded Funds in the early 1990s.

Like a mutual fund, an ETF is also a basket of securities. But unlike mutual funds (and similar to stocks), ETFs trade daily on an exchange with live intraday prices.

Rather than subscribing/redeeming units from the mutual fund house only once a day, investors can buy/sell their ETF units via their brokerage account anytime during market trading hours.

Exchange Traded Funds combine the diversification benefits of mutual funds with the liquidity and trading advantages of single stocks.

Are ETFs active or passive?

A strategy is defined as passive when it follows a systematic rules-based approach to selecting stocks that is predefined. It basically does not involve any “active” calls. Active strategies, on the other hand, involve a person (or a team) handpicking stocks depending on market conditions and his/her market views & taking judgment calls when presented with new information.

Most ETFs in the world today are passive – they either track an existing index like the Nifty-50, or follow a systematic rules-based approach to selecting stocks that is predefined and transparent.

There is no discretionary element in such ETFs, where a particular fund manager or investment committee will take active judgment calls based on their current and future market views.

However, ETFs can be active as well – in such ETFs, the fund manager has the discretionary power to break away from the systematic rules of their chosen benchmark and own a basket of securities that are different from the benchmark index.

The Global Popularity of ETFs

Since their launch, ETFs have become extremely popular with institutional and retail investors across the globe. The global financial crisis of 2008 was an inflection point for the ETF industry, as the low-cost & other advantages of ETFs came to the forefront of investor focus during this stressful time

Assets invested in the Global ETF industry reached $5.18 trillion in February 2019, the highest on record
Global AuM in ETFs has grown at 20.1% CAGR over the past 10 years
61 consecutive months of net inflows into ETFs listed globally
Not surprisingly, US is the largest market for ETFs in terms of asset size & offerings

Exchange Traded Funds in India

The first ETF in India was created in 2001, when Benchmark Mutual Fund launched the Nifty ETF Fund with a defined objective to track the performance of the Nifty-50 index. Since then, the ETF industry in India has witnessed a slow but steady growth.

There was a period in between when ETFs became associated with a convenient way to invest in gold, especially in the mid-late 2000s. However, the ETF landscape today has evolved to include different segments of the equities market, gold, fixed income, and even the recently launched real-estate focused REITs.

Advantages & Disadvantages of ETF

As mentioned, the ETF instrument was created in the 1990s whereas the mutual fund structure was created in the early 1920s. As such, ETFs build on the benefits of mutual funds by operating a more efficient structure that has many advantages for the retail & institutional investors, as well as the AMCs.

The Key Advantages of ETFs

	Exchange Traded Funds (ETFs)	Mutual Funds
Liquidity	ETFs offer instant liquidity & can be traded anytime during market hours	Subscription & redemption process can take 1-3 days
Diversification	They are a diversified portfolio/basket of stocks	They are a diversified portfolio/basket of stocks
Expenses	Expense ratio is usually lower than comparable MFs	Expense ratio is usually higher than comparable ETFs
Exit Loads	No exit load or penalties	Many funds charge 1% in case the investment is redeemed within 1 year
Cash Holdings	ETFs hold no cash - as such, all money is put to work	MFs can hold cash for the investor - often this drags down performance
Transparency	Very transparent; holdings published on a daily basis	Less transparency into holdings, which is published once a month
Advanced Trades	Expert investors can use ETFs to place limit orders & even trade in derivatives based on ETFs	Such expert trades can't be done with mutual funds

Disadvantages of ETF

ETFs that track an index suffer from something called tracking error. It is the difference between the index return and the fund return. Note though, this is also applicable to any passive mutual fund which is tracking an index
In rare times of poor liquidity, the bid/ask spread (i.e. the buying/selling costs) can be high leading to higher costs
In India, placing SIPs into ETFs aren’t as convenient as they are in mutual funds
Lastly, there aren’t many varieties of ETFs in India yet – current offerings are limited to large & midcap index trackers, gold, and debt. However, this will change as its popularity & penetration increases – today, the developed markets have all kinds of niche ETFs, but they started off in a similar vanilla fashion.

But the most commonly cited disadvantage of ETFs, at least in India, is that they don’t have enough liquidity. While this is partly true since increased adoption will definitely lead to better liquidity, the reality is that buying/selling Exchange Traded Funds will never be an issue due to third-parties called “Authorised Participants” (APs) and the creation/redemption process of ETFs.

This is exactly what we have explained in detail in the next post in the ETF Education Series. Read it here.

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This is the 1st post in the ETF Education Series. If you are new to Exchange Traded Funds or interested to learn more about them, we recommend reading the entire series: