Everything you need to know about ETFs

What is ETF?

It’s a pooled investment vehicle similar to a mutual fund offering diversified exposure to a particular market. It can invest in stocks, bonds, commodities, currencies, options or a blend of assets.

An ETF provider creates an ETF using a particular methodology and sells shares of that fund to investors, representing a proportional interest in the pooled assets. The provider purchases and sells the ETF’s constituent securities. Investors do not own the underlying assets.

Which was the first exchange-traded fund (ETF)?

The first ETF in India, Nippon India ETF Nifty BeES, was launched in 2002 by Benchmark Mutual Fund, which Goldman Sachs acquired in 2011. Goldman Sachs was then acquired by Reliance Capital AMC, which is now Nippon AMC.

SBI Nifty 50 ETF with Rs 122,897.59cr is the largest mutual fund in India as the Employees’ Provident Fund Organisation (EPFO) invests in this ETF.

Internationally it was SPDR S&P 500 ETF (SPY), launched by State Street Global Advisors on Jan. 22, 1993. Today it is the most traded security in the world.

How is an ETF different from an index fund?

A mutual fund that tracks an index is commonly referred to as an index fund. An index ETF is built similarly and will hold the equities of an index, tracking it. In ETF, the underlying asset is not bought and sold when you make a purchase, but in the index fund, they(AMC) buy and sell the securities for purchases and redemptions. You can also trade an ETF directly on a stock exchange throughout the day.

What are the different types of ETFs in Indian markets?

Equity ETFs

Equity ETFs are the most popular currently and generally track Nifty 50 and its other variants.

Bond ETFs

Bond ETFs are primarily meant to give investment options in fixed income instruments with varying maturities, such as debentures and government bonds. Bond ETFs combine the advantages of debt investing with the flexibility and simplicity of stock investments and mutual funds.

Commodity ETFs

Currently, the only commodity ETFs accessible in India are gold and silver. These ETFs attempt to replicate their respective bullion markets and enable investors to invest in precious metals digitally rather than in physical form.

Some features of commodity ETFs

• Each unit of gold in the ETF equals one gramme of gold.
• The price of ETF is on a real-time basis, and it trades close to the fair market price of gold.
• The proceeds are available on a T+6 basis upon redemption.

Sectoral/Thematic ETFs

A sectoral or thematic ETF is intended to imitate the performance of a specific sector.

International ETFs

An international ETF allows investors to invest in foreign companies. It attempts to replicate the global market index or any country-specific index.

For tax purposes, it is classified as non-equity:

• If you sell your unit within three years, you pay short-term capital gains (STCG) tax based on your income tax bracket.

• If you sell your unit after three years, a 20% long-term capital gains (LTCG) tax with indexation.

Smart Beta ETFs 

Generally, ETFs track a market-cap-weighted benchmark ( a market-cap-weighted index weights stocks based on their market cap (outstanding shares X current price). Higher the market cap, the higher the weight in the index.

SMART Beta ETFs are ETFs which deviate from this weighting methodology.They are made up of a list of stocks that have been chosen based on specific criteria.

Often, the criterion is a factor or a combination of factors such as low volatility, value, quality, or momentum. A Nifty Smart Beta ETF focusing on low volatility, for example, would include stocks from the 50-stock index that are less volatile than their peers.

Shariah compliant ETFs

These ETFs are based on Shariah Index. A Shariah Index is an index of companies that have been found to be compliant to Shariah. 

The screening is done at two levels, depending on the sector in which the firm operates and a few of the operating ratios with which the company works, as stated in their annual report.

For example, all companies in a specific index whose business domains are pork, alcohol, gambling, finance, tobacco, pornography, deferred gold and silver trading, and advertising and media (excluding newspapers ) would not be part of this index.

What are the things you must check  before investing in ETFs?

1. Arbitrage in the price of the ETF to its underlying NAV (net asset value).

The price of an ETF, like the price of a stock, can sometimes diverge from the underlying value. This can result in an investor paying a premium to buy an ETF that is higher than the cost of the underlying stocks or commodities in an ETF portfolio. And therefore should look at its NAV and iNAV.

NAV of the ETF

Like a mutual fund, an ETF has an end-of-day Net Asset Value (NAV). The NAV indicates the entire worth of the fund and the value of your assets. An ETF trades in real-time, whereas NAVs are only announced at the end of the day. 

So how do you figure out if your price for an ETF is fair in real-time?

You should check iNAV (Intraday or indicative net asset value).

Because ETFs trade in real-time, you need a reference point to determine whether the market price displayed on your trading platform is fair, and the indicative or intraday NAV (iNAV) serves as that reference. This is typically calculated every 10-15 seconds by AMCs and published on their websites. This is a real-time NAV, so you may use it as a fair value reference to compare to the current market price on the stock exchanges.

ETF Creation and Redemption

ETF share supply is managed by a method known as creation and redemption, which requires big specialised investors/brokers known as authorised participants (APs).

When ETF shares are scarce in the market, they generate more. When there is an excess supply of ETF shares in the market, they lower the number of shares through the creation and redemption mechanism to manage liquidity.

Creation When ETFs Trade at a Premium 

Imagine an ETF that invests in the nifty 50 stocks and has a price of 201 at the close of the market. If the value of the stocks in that ETF was only 200, then the fund’s cost of 201 is trading at a premium to the fund’s net asset value (NAV).

An AP is compensated for bringing the ETF share price back into balance with the fund’s NAV. To do this, the AP will purchase market shares of the stocks that the ETF holds in its portfolio and sell them to the fund in exchange for ETF shares. In this scenario, the AP buys stocks in the secondary market for 200 but receives ETF shares, which are trading in the secondary market for 201. This is known as creation, raising the quantity of ETF shares in the market. If everything else stays constant, increasing the number of shares available in the market will lower the ETF price and bring shares in line with the fund’s NAV.

Redemption When ETFs Trade at a Discount

An ETF holding stocks in the Nifty 50 Index is trading at 199 per share. If the value of the stocks that the ETF has in the fund is 200, then the ETF is said to be trading at a discount to its NAV.

Then the AP will buy the ETF in the secondary market and sell them back to the ETF sponsor (AMC) in exchange for shares of the portfolio of the underlying stock to restore the ETF’s share price back to its NAV. In this example, the AP can buy ownership of 200 worth of stock in exchange for ETF shares that it bought for 199. This process is called redemption, decreasing the supply of ETF shares on the market. When the supply of ETF shares is reduced, the price should rise and get closer to its NAV.

The amount of creation and redemption activity is determined by market demand and whether the ETF trades at a discount or premium to the fund’s assets.

2. Liquidity of ETF

Liquidity is a crucial consideration in exchange-traded fund (ETF) investing. ETFs have differing liquidity profiles for several reasons. Investing in an ETF with low liquidity may result in a wider bid-ask spread, fewer opportunities to trade effectively, and—in extreme cases—the difficulty to withdraw funds in certain scenarios, such as a major market crash.

3.ETF’s tracking error

The tracking error of an ETF is the difference between its returns and the returns of its underlying benchmark index. Tracking errors are usually moderate, and the largest, most owned ETFs have the least.

What are the Tax implications on ETFs?

• The tax on redemption of ETFs is calculated based on the holding term. 
• Regardless of their investment methods, FOFs are classified as debt funds.

How to invest in ETFs?

ETF transactions take place on the stock exchange where the ETF is listed. To invest, investors must have a trading account with a broker as well as a Demat account.

Should you Invest in ETF?

ETFs are one of the most cost-efficient means to gain exposure to the stock market compared to mutual funds and other pooled investment products. Because they are listed on an exchange and trade like stocks, they provide liquidity and real-time settlement. ETFs are a low-risk option because they replicate an index, providing diversity rather than investing in a few stocks of your choice.

ETFs allow you to trade in a variety of ways, such as selling short or buying on margin. ETFs can give investors access to a variety of different investment opportunities, such as commodities and international equities. You can also use options and futures to hedge your position, which is not available when investing in mutual funds.