In current times, there is one investment strategy that is slowly gaining attention. It is passive investing, where you can invest in an index like Nifty 50 or Sensex to generate the same returns as the index. Under passive investing, ETF or exchange traded funds are gaining huge traction from young investors to build a diversified, good portfolio with only ETFs.
However, ETFs at times can be tricky, especially for those who are unaware of how they are formed or lack the crucial information about factors to consider when availing of them. Here’s a brief on it:
Initially, you must know why it is necessary for you to know about ETFs? Firstly, active mutual funds, i.e., those funds that aim to overcome the market are witnessing hard times to sustain a higher return and many of them are lagging benchmarks. Choosing to invest in indices reduces the impact of a fund’s underperformance on the returns and eliminates the requirement to continuously keep note of the performance to remove poor funds to reinvest in better performing ones.
Next, the space of the ETF has been evolving. ETFs are now being formed on indices with sector opportunities, strategies, and behavior that are different from Sensex or Nifty 50 or even the mainstream mutual funds. Note that, low volatility, value based, alpha, private bank, quality based, target maturity debt indices are a few examples of distinct strategies. New ETFs aligned for introduction are indices structured on growth sectors, auto, electric vehicles, new age digital, and manufacturing, to mention a few. Well-rounded investment portfolio requires having a mix of styles and strategies to capture distinct opportunities to cope with both participation in rallies and downside containment. Differentiated indices are good additions to your portfolio as they may offer a return perspective that simply can complement your mutual fund portfolio.
Thirdly, few of the indices do not hold an index mutual fund variant. In most cases, even if there are index funds, they may invest in an ETF and not in an index directly. This brings an added expense layer, which is avoidable if you invest in the ETF itself. There are over ninety ETFs, spanning over a range of indices in debt and equity.
What are ETFs?
ETFs stand for exchange traded funds, which are introduced by the AMCs (asset management companies). They pick an index to track and divulge NFO (new fund offer) for an ETF. Amount collected in NFO is invested in index constituents in the right weights. AMC breaks the ETF into units. In the initial launch of an ETF, investors receive the units. Till here, this is what the index mutual fund also does.
ETFs differ from here. Units get listed on the stock exchanges and ensuing selling or investment happens with these units just on exchange. In simpler terms, post ETF introduction, you can purchase or sell the ETF just like you sell or purchase any share. For this, you will require a Demat account.
This brings the next crucial aspect – market price. As you know, NAV (net asset value) in mutual funds is the size of assets divided by the overall fund units. ETF too comes with a NAV because it is a pooled investment run down into units. However, NAV does not indicate the price at which ETF investment is done. Note that, you are only purchasing or selling the units on the stock exchange and not with AMC. Thus, you will have to bear the market determined price at the time of ETF investment. A major parameter that impacts this price is the index movement.
As per the ideal scenario, the market price will track exactly the index and underlying ETF NAV. Unfortunately, this is not the case. ETF market price is impacted by the demand for the ETF unit and its supply. In other words, if an ETF views more buyers on exchange and insufficient sellers, its price will go up and vice-versa. It may render market prices to go out of sync with the underlying movement of the index and NAV – where ETF return may be higher than index or on the lower end.
To manage ETFs well, AMCs ensure to see if the supply driven fluctuations are attended better by forming more units or managing the market activity for correction in price aberrations. A key point you must check in an ETF is to understand how closely it can track index i.e., how much ETF returns are deviating from index returns, which is called tracking error. A lower error indicates a better ETF.
In a nutshell, the instrument ETF has started to provide great opportunities that can act as an excellent diversifier in your investment portfolio. Thus, ensure to keep note of it.