What are ETFs and how do they work?

‘What happened? You look visibly upset,’ Ravi asked Shalini as the latter feverishly checked several notifications on her phone. Shalini looked up from her screen and retorted, ‘Hmm well, the Sensex is at an all-time high again, playing with 60k levels, but my portfolio is nowhere close! The pharma-focussed fund I’d bought midway through the first wave of the Covid-19 pandemic has dipped significantly in the last few months. Not that I’m going to sell it off, but it’s presently affecting my overall portfolio.” 

Shalini had learned quite a bit since her entry into equity investing. After trying out her hand at an IPO - the debut of a company on the stock market, she’d started building herself a diversified portfolio of mutual funds and stocks. She’s still figuring out things in the world of finances and has a very long way to go to actually be called an investor. 

‘My portfolio, too, is affected. I feel like I’ve completely missed out on the last leg of the rally,’ lamented Shoaib, who showed a concerned Ravi all the red on his phone’s screen. ‘I could’ve made quite some profit had I gotten out in February when it was all green and then maybe reinvested later.’ 

‘But that’s not a good approach for wealth creation in the long run,’ retorted Ravi. ‘Why don’t both of you consider allocating a portion of your portfolio in well-diversified ETF?”

"What is an ETF? Can it help me get out of my current confusion? Shalini asked in a single breath. Ravi knew it was time to deliver an important message. Here’s what he covered.

What are exchange-traded funds (ETFs)?

Exchange-Traded Funds (ETFs) provide a neat alternative to those who want to invest in the stock market but don’t want to put all their eggs in one basket or one company. They also can help investors who may be unsure about which company to pick to be a part of their portfolio.

But what is an ETF? An exchange-traded fund is a collective portfolio of financial instruments like stocks. While this is just like mutual funds, ETFs trade on the stock market and are bought and sold on an exchange during market trading hours, like stocks. Note that mutual funds can only be purchased and sold at a single closing price each day - the NAV – which is calculated after the day’s trading session is over.

The individual units of an ETF are also called shares. An ETF's share price trades just like a stock during the market hours of a typical trading day. These units may be traded on the stock market through brokerage accounts or online discount brokerages.

How does an ETF work?

ETFs initially kindled the interest of investors in the 1990's, especially those looking for a tool to marry the diversification benefits of mutual funds with the liquidity of openly traded stocks. The main reason why people invest in ETFs is to get exposure to various assets and asset classes while having one investment vehicle instead of having to manage multiple ones. 

Much like mutual funds, the biggest driver of the price movement of an ETF is the performance of its underlying assets. This means when the stock market is rallying, should the ETF be investing in those stocks that are seeing a price rise, the ETF share will also typically see a price increase. Similarly, if the ETF invests in stocks when the stock prices are falling, the respective ETFs will also see a decline in their prices. 

“This is great!” commented Shalini as she tried to make sense of what Ravi was talking about. “But is there an option among ETFs that simply follows an index instead of trying to make active investment decisions like picking specific stocks?” 

“Yes, sure! In fact, most ETFs track some index. That is what makes them passive investments in the first place. Though I must mention, not all ETFs track indices passively,” says Ravi. 

“Let me see if I’ve gotten this right”, Shalini cuts him. “I’m trying to sift through all the jargon here, but broadly speaking, there are two types of pooled investment funds that are hugely popular. One is an active fund where a fund manager ‘actively’ manages the fund composition, adding stocks that are likely to perform well and replacing those that aren't. The whole purpose of this exercise is to beat the benchmark indices...”

“That’s a good, fairly simplified synopsis of active funds, Shalini,” continues Ravi. “The other type is known as passive funds. They merely mimic the indices instead of trying to beat them, which is why the returns on these, match the market performance.”

One of the most popular strategies for investing in ETFs in India is to pick one that follows an underlying index, like the Nifty. Over the long term, the journey of the Nifty has been upward and from all accounts, remains likely to inch upwards. Look at the Nifty returns over the past decade.

Benefits of investing in ETF

1. Liquidity and Flexibility

ETFs offer instant liquidity since you can easily buy and sell them anytime during market trading hours. They are traded on leading exchanges just like common stocks, which makes them easy to trade.

2. Diversification across Asset Classes

ETFs, just like MFs can help you diversify risks across multiple instruments, industries, or asset classes. This means that your portfolio performance is not concentrated in a handful of stocks or industries. When a market segment or one asset class underperforms, another may outperform, thereby averaging out any dips in returns and securing your capital.

3. Lower Cost

Generally, as compared to actively managed mutual funds, the expense ratio of ETFs is lower. This makes these instruments a good proposition for cost-conscious investors.

4. Single Transaction

Because ETFs are ‘passively’ run, the number of buy & sell transactions are fewer than actively managed funds, where fund managers could trade actively to chase higher returns than their funds’ benchmarks. This frequent buy-sell churn in active funds can lead to higher tax since each transaction may command Securities Transaction Tax (STT) and face capital gains tax. Hence, ETFs can be considered more tax-efficient than active mutual funds.

“Oh! That’s a lot of useful information,” exclaimed Shalini. “I’ve been browsing different types of ETFs since we’ve been talking, and it seems like they are not entirely equity-focused either. They include a whole variety, including index-trackers, gold, bond, sector, currency ETFs and what not. Perfect for Shoaib - We all know how conservative & thoughtful he is as an investor!” 

“It’s not a bad thing to be risk-averse,” said Shoaib defensively. “I like to spread my risk around! Tell me what you’ve found, Shalini- what kind of ETFs are out there?”

ETF categories available in India

There are various types of ETFs available to those of us investing in ETFs in India. Some of the most popular ones include:

1. Equity ETF

These ETFs track price movement of leading stock-market-listed businesses often through tracking benchmark indices such Nifty50, Nifty Midcap, Nifty IT etc. 

2. Debt ETF

For those looking at consistent returns through ETF investing, a debt ETF might prove to be the answer. These ETFs track the movement in yields of government bonds and corporate debt instruments.

3. Commodity ETF

A commodity ETF tracks the price movement of metals such as gold and mirrors the returns made as the price moves up or down.

“That’s quite accurate, Shalini,” said Ravi proudly. “I see that you have been quite taken by the concept of ETFs in our chat!” 

The end game

“So how do you propose that one manages it all? Should I liquidate my mutual funds, deposits & bonds and switch to ETFs instead?” asks Shoaib- eager to take the next step.

“No, not at all!” said Ravi. The secret to long-term wealth creation is to be well-diversified across market segments and asset classes. And ETFs are just one such way to help you do so- think of them as passive sisters to Index Funds. On the other end of the spectrum are their cousins- ‘active’ Mutual Funds. One can build a portfolio with a good mix of active funds & passive funds including ETFs. That’s how you maximize returns in the long run while also being thoughtful about managing risks.

“So, have we successfully chased the market blues away?” asked Ravi, with a chuckle.

“I believe we have,” replied Shalini with a convincing smile.

Shoaib remembered something just then… “I have heard of a ‘Core and Satellite strategy somewhere- some of the most reputed fund managers advocate this method?”

“Right. The crux of it is that you can create a portfolio in such a way that you invest majority of your capital in passively managed funds such as index funds or index ETFs that will become the core and provide you stable returns in line with the market performance…,” said Ravi

“And your satellite investments are more risky- these help you chase market outperformance,” interjects Shoaib.

“Correct, you can look at different funds with different management styles as part of your satellite, that try to beat the market and chase superior returns. This will ensure that the bulk of your money keeps compounding year-on-year at a low cost while a smaller proportion can be allocated to high-risk high-return ideas.” finished Ravi.

“Sounds like a plan,” says Shalini as Shoaib looked on, visibly impressed.

Like Shoaib, are you also interested to know more about the famous ‘Core and Satellite’ strategy? Here’s where you can read about it.