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  • Rajvi Haria

ETFs

Heard of NIFTY-BEES ? Nifty Bees is India’s first ETF launched in January 2002. But what do we understand by the term “ETF” ?

ETF or an Exchange Traded Funds is an investment fund which is a combination of Mutual Funds and Stocks. Like Mutual Funds, people pool their money together in a fund that invests in different assets like stocks, bonds, commodities and other securities. Also, just like individual stocks (For eg: Reliance). ETFs can be bought and sold on exchanges anytime during the day thus carrying a better liquidity option and offering the opportunity of intraday trading. It is kind of a Mutual Fund that you can buy and sell in real-time at a price that change throughout the day.

Most ETFs are passive instruments and they closely track an index. Being passively managed makes ETFs expense ratio far less than mutual funds giving better returns. Thus, apart from low costs ETFs also offer increased transparency, no exit loads and instant liquidity. ETF may also provide risk management through diversification, however there are ETFs that focus on targeted industries reducing the diversification effect. Another benefit of ETFs is that they have less tax burden.

As most ETFs track an index it should not outperform or underperform the index. These are rebalanced whenever the index is rebalanced. For example, ICICI Prudential Nifty ETF tracks the Nifty50 index which gives an overall performance of the whole market. Similarly, the AXIS Gold ETF tracks the gold prices in India.

There are also ETFs which track the performance of foreign Stock Markets like the Motilal Oswal Nasdaq 100 ETF which tracks the US Nasdaq index. Thus, if anyone who wish to invest in foreign markets can easily put money in such ETFs. Recently ETFs are launched that track the Real estate prices. These are known as REITs.

One of the things that makes ETFs unique is that you can invest in ETF with a fraction of the cost and get exposure to a particular security. Let’s say you have to buy the Nifty Index that means you have to buy all the 50 stocks present in Nifty which will cost you Rupees one lakh instead you can buy one unit of ICICI Prudential Nifty ETF in just Rupees 120 and get exposure to the Nifty Index. Similarly, if you think that Real Estate prices are going to increase in the coming years and you want to invest in actual real estate, it would cost you around lakhs or crores but with Embassy Office Parks REIT, India's first listed REIT- ETF you can get exposure to real estate in just Rupees 400.

ETF can also be used for the purpose of arbitrage or hedging. For example, buying Gold as a commodity and selling a few units of the AXIS Gold ETF. But what exactly are Gold ETFs and why should one prefer buying a Gold ETF instead of buying Physical Gold?

Gold ETFs-

  • A Gold ETF is an exchange-traded fund (ETF) that tracks the domestic physical gold price. They are passive investment instruments that are based on gold prices and invest in gold.

  • One Gold ETF unit is equal to 1 gram of gold and is backed by physical gold of very high purity. Gold ETFs are represented by 99.5% pure physical gold bars. Hence it ensures Purity of Gold whereas while buying physical gold purity of gold always remains a question.

  • Since the Gold ETFs are in an Electronic form, the risk of handling physical gold and storage cost is very low.

  • Also, Gold ETFs are tradable on exchange and hence if you wish to sell your investment in gold, you can do it from your home rather than travelling to a shop to sell your physical gold bars.

  • Another benefit is that if you ever wish to convert your Gold into jewelry, AMCs also permit redemption of Gold ETF Units in the form of physical gold in ‘Creation Unit’ size, if one holds equivalent of 1kg of gold in ETFs, or in multiples thereof.

Choosing The Right ETF-

There are several ETFs that track a particular asset class. For example, the HDFC Gold ETF, UTI Gold ETF, and the Nippon India Gold ETF all track the Gold price. Another example could be the SBI Nifty50 ETF, HDFC Nifty50 ETF, Kotak Nifty ETF that track the Nifty Index. The question is that after deciding to put money in a Nifty ETF which one should you choose? Well there are many parameters to look at while choosing the right ETF. Few of them are:

  • Liquidity: An ETFs liquidity includes two things to look at. The liquidity of the fund itself and the liquidity of the underlying units. One should look at funds that have a higher average daily trading volume and more assets under management.

  • Tracking Error: Most investors look at a funds expense ratio, the lower the better. But, one should also look at a funds tracking error. Tracking error is defined as the annualised standard deviation of the difference in daily returns between the Index fund and its target Index. In simple terms, tracking error is the difference between returns from the Index fund to that of the Index. If an index is up by 12.25 percent, a fund should be up 12.25 percent too. But that's rarely the case. First, expenses pull down returns. If you charge 0.25 percent as annual fees, your expected return should be 12.00 percent (12.25% - 0.25% in annual fees). However, there are ETFs that provide a lesser return than the expected 12%. This leads to a higher difference between the ETF returns and the actual Index returns. The standard deviation of this difference is known as the tracking error. All else being equal, the fund with the minimum tracking error should be the one to choose.

ETFs are a great means for investment, but one should wisely choose the correct ETF for greater benefits.

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