Exchange-traded Funds

Considering the performance and historical returns of the Indian financial market, investors have realized that the highest possible returns can be achieved by investing in various lucrative instruments. As it has provided consistent profits and liquidity, more investors are entering the financial market through various instruments such as equity, derivatives, currency, bonds, etc.

Professional investors are knowledgeable about analyzing companies, stocks, and the market trend through fundamental and technical analysis. A new investor entering the market without prior knowledge can end up investing in a bad stock, forcing losses on the capital invested.

What if you want to invest to earn passive income and not spend valuable time understanding every single factor related to the financial market? Can you still invest? Or are you always at the risk of making losses?

The answer is Yes. However, the choice of investment is vital. One such financial instrument is Exchange Traded Funds (ETFs). This blog will help you understand what are exchange-traded funds and the exchange-traded funds definition to help you enter the financial market effectively or diversify your current portfolio.

What are exchange-traded funds?

Exchange-traded funds are types of Mutual Funds that aim to track the performance of a specific index such as NIFTY 50, NIFTY Next 50, NIFTY Bank, etc. An index is a basket of stocks representing certain segments of markets.

For example, NIFTY 50 is a basket of the top 50 companies on the National Stock Exchange, chosen from different sectors of the economy. Exchange-traded funds invest in the same stocks as those in the index and the same proportion as their weight in the index. Hence, they can mirror the performance of the underlying index. These exchange-traded funds can be based on indices tracking various asset classes like equity shares (e.g. NIFTY 50 ETF), bonds (e.g. 10-year G-Sec ETF), Gold (e.g. Gold ETF), Tri-party Repo (e.g. Liquid ETF), etc.

ETFs are called passive funds because the fund manager does not try to outperform the benchmark index but instead tries to mirror its performance. For example, a NIFTY 50 ETF seeks to generate a similar return to the NIFTY 50 Total return index. As no active fund management is involved – the fund management fee is very low and cost-saving is high for investors, which impacts returns over the longer term.

How do exchange-traded funds work?

Think of a basket that has several stocks and a market where these baskets are sold. You can just go to such a market, browse the baskets and choose the one you think can be the most beneficial to you. This is the central idea behind exchange-traded funds. The market here is the stock exchanges of India, and the basket is exchange-traded funds.

Like a mutual fund, the exchange-traded funds also pool all the investors’ money in baskets of securities with a predetermined weightage. These baskets made via creation blocks are listed on the stock exchanges as a single entity and can be bought and sold as one does with shares. Furthermore, ETFs have a single price that fluctuates based on the prices of the included securities and the weightage. If the share price of an underlying asset rises, the price of the exchange-traded funds also rises in the same proportion and vice-versa.

The holders of exchange-traded funds are also liable to receive the dividend. The dividend amount that they receive depends entirely on the financial performance, asset management, and profits of the exchange-traded funds’ company.

Exchange-traded funds can be operated actively or passively. Actively managed exchange-traded funds are those that are managed by professional portfolio managers who execute extensive market research and assess the stock market conditions before adding a stock/share into the exchange-traded funds. On the other hand, passively managed exchange-traded funds do not rely on extensive market research but follow the current market trend of an index. If a company is listed on the rising charts, such exchange-traded funds add the company to the fund’s basket.

Types of exchange-traded funds

Numerous types of exchange-traded funds are listed on the exchanges that an investor can use to diversify, speculate, hedge, or make profits in the financial market. These exchange-traded funds are:

• Stock exchange-traded funds: Stock ETFs include a host of stocks of various companies in a predetermined proportion. These types of exchange-traded funds are made to track a particular index or sector and mirror its performance. For example, a stock ETF can be made for the metal sector, where the ETF basket will contain high potential pharmaceutical stocks.
• Bond exchange-traded funds: Like traditional bonds, Bond ETFs are also created to provide a regular source of income to the investors. The basket includes various bonds such as government bonds, state bonds, corporate bonds, etc., allowing investors to receive interest based on the performance of these underlying bonds. However, unlike traditional bonds, bond ETFs do not have a maturity date.
• Gold exchange-traded funds: A gold ETF is a form of investment associated with domestic gold prices. They are passive instruments that allow investors to invest in gold bullion without physically buying Gold directly. Just like a stock market investment is carried out by buying ‘stock’, which is nothing but one unit of a company, a gold ETF is invested in by buying units of high purity gold where one unit is equal to one gram of gold.
• Currency exchange-traded funds: These types of exchange-traded funds allow investors to trade in a basket of currency pairs as these funds track the performance of the currency pairs. These can include both domestic and foreign currency pairs. Currency ETFs allow investors to make profits based on the overall exchange rate and the resulting price fluctuations.
• Commodities exchange-traded funds: These types of ETFs create a basket around commodities such as metals, agriculture, livestock, etc. Commodities ETFs are one of the best ETFs used by investors to hedge against the equity market and diversify their portfolios. As commodities have an inverse price relation with equities, they allow investors to mitigate their portfolio risk in case the stock market falls.

How are exchange-traded funds created?

An Asset Management Company plans the ETF and decides what assets will be included and details such as fees and the number of shares it will create. The ETF is an exchange-traded product and is subject to SEBI approval. Normally, after the approval, the authorized participants (large institutions and HNIs) will start buying shares of the ETF. Exchange-traded funds don't sell their shares individually but sell huge chunks of shares. Such chunks are referred to as creation units or blocks.

Once the Creation units are ready, they are traded for equivalent amounts of the shares’ assets. These shares are placed with a custodial bank so that the ETF units that are issued to the retail investors are fully backed and secured. This applies to index ETFs and gold ETFs. They are then managed by a fund manager whose primary role is to ensure that the portfolio reflects the underlying asset class and reduce the tracking error to the lowest level possible.

Final Words

Exchange-traded funds are financial instrument that aims to mirror the performance of a specific index or sector they are tracking. As ETFs can be bought with any underlying asset such as gold, silver, commodities, etc. They are an effective way to let investors diversify within the asset class and then within the held assets. However, you will need a Demat and trading account to buy and sell ETFs, which you can open for free by visiting IIFL’s website or downloading the IIFL Markets application.