What is an exchange traded fund (ETF)? How is it different from a normal equity fund? I have heard that ETFs have the lowest expense charge. If ETFs turn in a superior performance, can one invest in them and save expenses too?
Dipika Sharma, via e-mail
An exchange traded fund (ETF) is similar to an index fund. Like an index fund, an ETF also comprises a basket of securities, which are part of a pre-decided index, in the same proportion as that of the index. For instance, Benchmark Mutual's BeES, the country's first ETF tracks the S&P CNX Nifty Index. If you buy one Nifty BeES, you will own all the shares that make the Nifty in the same proportion as the index. Prudential ICICI's SPiCE is an ETF scheme that tracks the BSE Sensex.
An ETF is also an open-ended mutual fund, like an index fund. It benchmarks its holdings and performance against a particular index. But that is where the similarity ends.
ETFs and index funds are different in terms of how an investor will buy or sell them. ETFs are traded on a stock exchange and investors can buy or sell them through their broker as the index changes throughout the day. An index fund,on the other hand, is bought and sold through the fund house or its distributors at the previous day's closing NAV. The value of an ETF is easy to calculate, as it is a fraction of the value of the index. While the BeES units trade at one-tenth of the Nifty value, SPiCE trades at one-hundredth of the Sensex value. An index fund normally starts at a value of Rs 10, and then changes as the index changes.
Another difference is that the index fund trades at the underlying value of the portfolio determined in its NAV, but an ETF scheme may trade at a premium or discount to its value, depending on the demand and supply in the market.
The best part about dealing in ETFs is that they cost less than index funds as not much of marketing and distribution effort is required to sell this product. For an index fund, there is a one-time load of 1 per cent and the annual average expense is 1.5 per cent. Benchmark BeES's expense ratio is much lower at 0.8 per cent, but an ETF has both entry and exit costs, as you have to pay commission to your broker when you buy and sell.
Though you know enough about ETFs now, do not take the plunge just yet. Analyze whether you actually need a fund that can trade like a stock. This entails interacting with the broker and maintaining a demat account. The ETF provides you an option of buying the fund throughout the day, so you can try to buy low and sell high. This should appeal to professional traders who want to time the market, but most of us are better off investing for the long-term.
The difference between index funds and ETFs on the one hand and actively managed equity funds on the other is more important. You have to know if you will be satisfied with average returns from ETFs, as the value of your investments will be determined by the performance of the underlying index. Remember that three-fourths of the funds which have been around for more than five years have outperformed the Sensex on a since-inception basis.
This article was originally published on July 10, 2003.
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