Exchange Traded Funds (ETFs) were first launched in India in December 2001 by Benchmark AMC. Now, a total of five ETFs are available to investors. ETFs are fundamentally different from normal funds and have thus developed something of a reputation for complexity. While some of the details of how AMCs run ETFs are genuinely more complex, that has nothing to do with investors. For the investors, ETFs are a straightforward instrument that offers some interesting features. Let's see what makes ETFs different.
ETF are index funds. An index fund is an equity fund, which tracks a particular market index like the BSE Sensex or the Nifty. The index fund holds the same stocks as the underlying index and in the same proportion as the index. From an investment point of view, ETFs are simply index funds that—unlike normal index funds—can be bought and sold at intra-day prices throughout a trading day. In this respect they are more like shares rather than like mutual funds. Normal index funds are, of course, available only at end-of-day NAVs from fund distributors like any other fund. ETFs, since they need to be transacted upon throughout the day, are bought and sold through stockbrokers (using a demat account) just like shares.
However, behind the scenes, ETFs are very different from any other kind of fund. Where an ETF really differs from an index fund is the manner in which it is created, bought and sold. In the case of normal mutual funds investors pays cash to the fund, which in turn buys the stocks and bonds which constitute the fund. When ETFs are first set up the initial participants will give the fund the basket of stocks, which constitute the underlying index and take units of the fund in exchange. These market makers will in turn sell these units to investors just like a distributor does. The market maker is usually a broker. Since ETFs are sold through brokers, you will pay brokerage in place of loads. ETFs tend to have lower brokerage than normal funds have loads.
The NAV of an ETF is a fraction of the value of the index. Thus the NAV of an exchange-traded fund based on the Nifty can be one-tenth of the value of the Nifty. If the Nifty is at 1500 points the NAV will be Rs 150. Effectively, this fractional pricing means that a basket of stocks like the Nifty can be purchased by an investor with a much lower outlay than it would otherwise be possible. Compare this with trying to replicate the index by purchasing individual shares, where just one share of Infosys costs around Rs 4500. This is also enables smaller initial investments than what most index funds offer, which is specially useful if you are just trying out index investing. By comparison, most nifty index funds require a minimum investment of Rs 5000.
In the case of other mutual fund schemes the fund buys back and sells units. In a way, an ETF resembles a close-end scheme, where the units are not sold back to the fund and investors buy and sell the fund units on the market. However, there is obviously no discount to NAV like closed end funds. Also, unlike a close-end fund supply can be altered by creating additional units or extinguished by withdrawing existing ones. Trading of the units ensures that underlying stocks do not have to brought or sold. Investors entering and exiting do not also affect existing investors. As a result an ETF has a much lower tracking error than an index fund. Currently the equity ETFs available track the BSE Sensex, the S&P CNX Nifty and the S&P CNX Nifty Junior. The ETF on the Nifty Junior is in fact the only option for passive investing in mid-cap shares. On the debt side a liquid ETF is available.