ETF: Exchange Traded Fund Primer For Absolute Beginners

What are Exchange Traded Funds and how does it work?

I always feel:

The world of finance has many investment options to offer, but you first need to identify your goals and the kind of risk you are willing to take. Once you have identified your investment objective, you just need to commit yourselves to stick to the plan, no plan is good if you are not invested in it for long.

Today we will discuss one such investment options which have become popular amongst both retail and institutional investors, who don’t want to spend time picking a single stock and still want to get a decent return with minimum risk from the stock market.

Yes, you guessed it right it is called- Exchange Traded Funds.

What Are ETFs?

If you are looking to the ease of stock trading and also the portfolio diversification power of mutual find ETF is the right product for you

The ETF definition is coined from these three components:

  • Exchanges: NSE/BSE
  • Trading: Selling and buying securities on stock exchanges
  • Funds: Pooled funds to be invested in a basket of stocks

ETF is a kind of passive mutual fund where securities are pooled in the form of a basket that tracks a stock index, commodities, sectors, or other asset classes. Unlike mutual funds, ETFs can be traded on stock exchanges just like any other stocks.

In ETF the underlying investment funds are generally invested in stocks passively mirroring the composition of indices.

ETF Category :

Here are some of the ETF categories :

1. Equity ETFs:

There are broadly two categories of equity ETF

  • Vanilla market-cap-weighted ETFs that track indices like the Nifty 50, Nifty 100, Sensex, etc
  • Smart beta ETFs that target factors such as value, quality, low-volatility, momentum, etc.

2. Debt ETFs:

Debt ETFs allow the investors to get exposure to fixed-income securities. These debt ETFs combine the benefits of debt investments with the flexibility of stock investment and the simplicity of mutual funds.

These Debt ETFs trade on the cash market of the National Stock Exchange, like any other company stock, and can be bought and sold continuously at live market prices.

Example:

  • LICNMFET by LIC Nomura invests in G-Sec (government securities)
  • Bharat bond ETF issued by PSUs,
  • CPSE+SDL ETF by Nippon which holds PSU bonds and State development loans (SDLs).
  1. Commodity ETFs:

A commodity ETF is an exchange-traded fund (ETF) invested in physical commodities, such as agricultural goods, natural resources, and precious metals like gold and silver. A commodity ETF is usually focused on either a single commodity held in physical storage or investments in commodities futures contracts.
Example:

List Of Indian ETF(On NSE)

How Does ETF Works?

ETF functions quite similarly to mutual funds, here fund providers pool investor money and create a basket of assets that they trade on the NSE and BSE stock exchanges. The investors become the shareholders of the curated ETF basket which is backed by underlying assets, but investors do not directly own the assets themselves.

ETFs track the return of an underlying index. An underlying index could be any index listed on the stock exchanges around the world like the Nifty 50 or Nasdaq 100 etc. The ETFs hold shares in the exact weights as the underlying index which is designed to track

Here is the Summary Of How ETF Works:

  • ETF fund providers create a basket of securities like equity, bonds, commodities, and currencies with a unique market price ticker
  • Investors can opt from multiple ETF baskets to invest
  • Investors can buy and sell the ETF baskets just like stock trading on the stock exchanges.

How Does ETF Differ From Mutual Fund?

ETF Vs Mutual Fund

I have simplified the differences in the tabular form below

ETF Vs Index Funds:

ETF fees and Charges:

Investing in ETF does attract certain costs & charges that impact the expected returns, so whenever you are planning your goals you should factor in these costs.

Majors cost factors go in the form of :

  • Expense Ratio
  • Brokerage, STT, and Other Charges

Let’s understand these cost components in detail:

Expense Ratios:

An ETF’s expense ratio indicates how much of your investment in a fund will be deducted annually as fees. A fund’s expense ratio equals the fund’s operating expenses divided by the average assets of the fund.

The expense ratio typically ranges between 0.1 % to 0.7 % per annum and it is expressed as a percentage of the fund’s assets under management (AUM). The fund’s operating expenses include spending on administration, management, and advertising

How to find the best ETF expense ratio?

A good rule of thumb is to not invest in any fund with an expense ratio higher than 1% since many ETFs have expense ratios that are much lower. Also, ETFs tend to be passively managed, which keeps the management fee low.

Brokerage, STT, and Other Charges:

Brokerage:

While you trade ETF you should be aware that your broker will charge certain fees called the brokerage charges that generally fall around 0.01 % of the turnover value.

SEBI Charges:

Then there are certain charges which go to SEBI for your stock purchase via the ETF route.

STT: Securities Transaction Tax

Securities Transaction Tax is not applicable on GOLD ETFs, LIQUID/Gilt ETFs, and International ETFs.

For other ETFs the STT is -

  1. 0.001% on the sell-side for delivery-based trades (including sell leg of btst trade)
  2. 0.025% on the sell side for intraday (non-delivery based) trades

Demat Transaction Charges(DTC) :

It ranges from Rs. 15–40 depending on your broker and his Depository Participant.

18% GST is also charged by the Government of India on brokerage + transaction charges.

In totality, the net charges stand close to 0.5–1.0% of your total Assets Under Management (AUM).

Are all ETFs passive?

Most of the popular ETFs are passive ETFs that track either the Nifty 50 or Sensex 30.

But there are some ETFs called smart beta ETFs that are not passive they are more of a hybrid of active & passive

Globally, 80–90% of all ETFs are passive, but ETFs need not be all passive, it’s just that they are passive today

Things to know before you buy an ETF.

  1. Choose the limit order option:

It is advisable to go for a Limit order while trading ETFs instead of a market order.

Limit orders help investors pre-determine their buy and sell price points. When trading ETFs, limit orders specify the exact price at which you are willing to enter or exit a position. While this is never an easy decision, it can help you protect against a declining market in the case of a stop-loss order.

2. Keep a close track of trading activity in the first and last 15 minutes of the trading day

There seems to be a finding that during the first and last 15 minutes of any given trading day, market behavior is extremely volatile. You can expect greater volatility toward the end of the day as market managers their order book and balances the same.

A good rule of thumb is to restrict buying and selling to 30 minutes after the market opens and 30 minutes before the market closes.

3. Be Aware of Market Liquidity:

ETFs are generally touted as a more liquid alternative as compared to other asset classes like mutual funds, and stocks, to take advantage of this one has to ensure they are picking ETFs that have high trading volume. While high volume doesn’t always assure liquidity, it can narrow the ETF’s bid-ask spread.

The market with high liquidity gives you an opportunity to enter and trade at a lower transaction cost and at the desired price

So for effective investing, implied liquidity and average daily volume should be used in tandem.

4. Always check the iNAV

Before you place your ETF limit order it is recommended that you visit the AMC website and check the current iNAV

The intraday net asset value (“iNAV”) provides an intraday indicative value of an ETF based on the market values of its underlying constituents. The value is calculated by the listing exchange and then disseminated to the public every 15 seconds.

5. Always do homework before picking the ETF of any AMCs

Many AMC may not be focusing much on the ETFs they have launched. AMCs like Mirae and Edelweiss, do seem to be committed to strengthening their ETF offerings. The best way to identify AMC is to analyze the track record in terms of the trading volume. So do your thorough due diligence before picking any AMCs ETF.

6. Trading “Large Blocks” of ETFs

Trading a large ETF block that has shares anywhere between 5k -10k is a better strategy. Large blocks minimize your market risk along with offering the best trading price.

Block trades are usually executed through an expert intermediary that specializes in such transactions. They can help you weed out volatility when trading large blocks of shares.

Summing Things Up:

ETF trading can be one more financial instrument in your kitty to generate decent market returns if you are well aware of the associated market risk and the best practices one should follow before trading ETFs.

Having said that it is imperative to understand that

“To reach your desired investment goals that can be short-term or long-term you need to have a portfolio which has a mixed set of assets and has the ability to mitigate market risk. ”

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@pramodAIML

@pramodAIML

Passionate Blogger & Tech Entrepreneur | Founder of FinTech Startup | Write about AIML, DevOps, Product Mgmt & Crypto