From time to time, analysts and writers suddenly start paying attention to passive investment vehicles like index funds and ETFs. Generally, this is the case at a time when various indices manage to do better then investors and mutual funds, or when different parts of the markets move at decidedly different pace. Not only are we in such a situation currently, such cases have occurred more regularly. Such funds are called passive funds because they don't require investment management in the normal sense. There isn't a fund manager who is responsible for deciding what to invest in. Instead, the fund is a mirror of a market index like the Sensex or the Nifty or any other index.
Exchange traded funds (ETFs) are a special case of index funds. They are mutual funds but are bought and sold like shares. When you want to buy or sell one, you go not to a mutual fund salesman but to a stockbroker. This route of buying a fund means that you need a demat account but if you already have one it's probably more convenient than the normal route of buying a fund. Unlike a normal mutual fund where you buy and sell units from the fund company itself, ETF units are traded on the stock markets between investors. However, the fund company arranges to absorb any excess supply of units that an investor would like to sell or create fresh units when the demand for units is large enough. As a result, unlike normal shares, the trading price of ETFs is not supposed to be heavily impacted by any demand-supply imbalances. ETFs are inherently very low-cost funds. While an actively managed mutual fund often deducts expenses of up to 2.25%, ETFs are generally in the 0.3% to 1% range. With compounding, this can build up to a significant difference over time.
ETFs are supposed to be good for those who just want to 'buy the market', that is, buy an index fund. Besides low cost, their quick and guaranteed liquidity also make them attractive to many investors. The fact that they can be bought and sold throughout the day at a currently available price can be a better way of trading in the broad market than a normal index fund that is available only at day-end NAV.
However, regardless of what the theory of ETFs says, Indian ETFs have been exhibiting some decidedly non-ETF like behaviour. ETFs are not very popular in India yet, and their low volume means that the quoted price of some ETFs often meanders away from a tight correlation with the underlying index. Still, over a long period, ETFs always give returns that are near-identical to the index.
Curiously, many investors have only heard of ETFs in the context of Gold ETFs. Whenever the price of gold zooms up, there is renewed interest in gold-based funds but these are all ETFs. Those investors who don't have a demat account and a regular stockbroker have trouble buying these funds. To make it easier for such investors to invest in gold ETFs, fund companies are trying to launch normal mutual funds that invest in gold ETFs.
I'm not sure whether ETFs will ever become popular in India. Their low cost should make them the default choice as passive investing becomes more popular. However, the low volumes and divergence from the underlying indices could result in a chicken-and-egg situation which could hold back ETFs from playing a larger role.
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