What is Exchange Trade Fund (ETF)? Features and Classifications of ETFs

ETFs are the mutual fund units that investors can buy or sell at the stock exchange. This is in contrast to a normal mutual fund unit that an investor buys or sells from the MNC . In the ETF structure, the AMC does not deal with investors or distributors directly. Units are issued to a few designated large participants called authorized participants (APs). 

  APs provides buy or sell quotes for the ETFs on the stock exchange, which enables investors to buy and sell the ETFs at any given point of time when the stock markets are open for trading. Buying and selling of ETFs requires investors to have a demat and trading account.

Origin and development of ETF

      The origin of ETF can be traced back in 1989, when the trading of index participation shares started on the American stock exchange and the Philippine stock exchange.

      In India, the first ETF was launched in December 2001 by benchmark mutual fund. The name of the product was NIFTYBEES and it was based on the Nifty 50. In 2003, LIQUIDBEES became the first ever liquid ETF in the world. In 2007, GOLDBEES was introduced, which was the first gold ETF introduced by the Benchmark AMC.  

Concepts of ETFs

•  ETFs are derivatively priced financial instruments which track a given underlying, including stocks, bonds, commodities or a basket of assets like an index fund. These are actively traded on intra-day basis in a stock exchange. ETF enjoy a unique trading mechanism with dual market structure. In the primary market it is open only to the authorized participants who can create and redeem ETF shares in kind directly from the fund in lots.

• On the other hand, in the secondary market these are open to all investors who can trade on them on a real time basis.

•  Accordingly ETF has two different price; net asset value(NAV) at which ETF shares are created and redeemed in the primary market and the price which I determined through the interaction of demand and supply of ETF shares in the secondary market. When the buying and selling pressure are on a higher side these two prices may significantly deviate from one another.

 Classification of Exchange Trade Funds (ETFs)

ETF can be classified in many way:

1. Nature of underlying:

according to the nature of underlying there can be commodity ETFs such as gold ETF(e.g. share goldbees), currency ETFs (US dollar money market ETF) or index ETF. Index ETFs are further classified as equity ETF and fixed income ETF.

2. Management style:

according to the fund management style ETFS can be either passively managed ETFs or actively managed ETFs. However majority of the ETFs around the world are passively managed.

3. Physical and synthetic ETFs:

ETFs can also be physical where the underlying is a particular asset class and synthetic where the underlying are some swap or collateral. Synthetic ETFs use financial engineering to achieve the benchmark return instead of holding the security itself.

4. Others:

Apart from the above there are some recent innovation in ETFs such as leverage ETF and inverse ETF. Leverage ETFs promise returns that are more sensitive to market movements. Inverse ETFs on the other hand are designed to perform inversely with the benchmark it follows. Both these ETFs use financial engineering to achieve their objectives.

Features of ETFs

ETFs offer a number of unique characteristics including the following;

1. Dynamic pricing:

Though in term of generic nature, ETFs resemble mutual funds, they are traded intra-day in stock exchange just like shares and hence are continuously priced.

2. Similar to derivative:

Similar to derivatives, ETFs track a given underlying. As a result their value fluctuates with the fluctuation in the price of the underlying. For example, gold ETFs have physical gold as their underlying. Hence the price and NAV of gold ETFs fluctuates with the price of physical gold.

3. High transparency:

Since ETFs are designed to replicate the performance of their underlying, investors are least assured about the composition of their portfolios.

4. Tax efficiency:

ETFs are mostly passively managed and hence are characterized by lower turnover and les realized capital gain. Since these capital gains are actually shared by the investors, ETFs offer greater tax efficiency.

5. Low cost:

Due to its passive management style, ETFs pay lower management and administrative fees as compared to traditional actively managed mutual funds. Lower cost positively affects the returns of ETFs.

6. High liquidity:

ETFs are highly liquid as the shares are traded on a real time basis. Hence investors can easily sell their holding and realize their investment at an efficient price.

7. Diversification and precision:

Through index ETFs investors can invest in multiple securities and can enjoy better diversification. In case of other ETFs which invest in particular asset class the precision is really appreciable.

Advantages of ETFs over a mutual fund:

1. ETFs are continuously traded and can be sold or purchased on margin.
2. There are no capital gain tax trigger when the ETF is sold.
3. Investors buy from brokers, thus eliminating the cost of direct marketing to individual small investors. This implies lower management fees.

Disadvantages of an ETF over a mutual fund:

1. Price can depart from NAV (unlike an open-ended fund.)
2. There is a broker fee when buying and selling(unlike a no-load fund.)

Conclusions

ETFs combine the risk factors of stocks with the divarication of funds, which makes them minimally risky for investors. It’s good for those investors who have no idea about security markets. If you want to invest in ETFs, then check out NSE ETFs market watch.