I have recently realised that more than a few casual fund investors seem to be under the impression that the term ETF, which stands for exchange traded fund has something to do with gold. Nothing could be further from the truth; it’s easy to see that source of this misconception. In recent months, there has been a number of high-profile advertising campaigns for that are called Gold ETFs. These are funds that do with gold what normal funds do with stocks and bonds. If you’d like to invest in gold but are worried about quality and physical safety, these funds offer an excellent alternative. But as it happens, all gold funds are ETFs and all ETFs that were widely advertised were gold funds and thus some investors have formed a notion that the two are connected. Nothing could be further from the truth.
Non-gold ETFs have existed for more than five years and while they are a niche, they form an excellent investment avenue in certain situations. In fact, the largest equity mutual fund in India is actually an ETF (Benchmark AMC’s Banking BeES), even though the reasons for this particular fund being so large are due to its being a banking index fund rather than an ETF.
Exchange traded funds are mutual funds but are bought and sold like shares. When you want to buy or sell one, you go not to a mutual fund salesman but to a stockbroker. This route of buying a fund means that you need a demat account but if you already have one it’s probably more convenient than the normal route of buying a fund. Unlike a normal mutual fund where you buy and sell units from the fund company itself, ETF units are traded on the stock markets between investors. However, the fund company arranges to absorb any excess supply of units that an investor would like to sell or create fresh units when the demand for units is large enough. As a result, unlike normal shares, the trading price of ETFs is not heavily impacted by any demand-supply imbalances. The price moves more or less in line with the value of the stocks in the underlying index on which the ETF is based. As is obvious from this description, ETFs are inherently very low-cost funds. While an actively managed mutual fund often deducts expenses of up to 2.5%, ETFs are generally in the 0.3% to 1% range. With compounding, this can build up to a significant difference over time.
ETFs are a good way for participating in the stock market for those who just want to ‘buy the market’, that is, buy an index fund. Besides low cost, their quick and guaranteed liquidity also make them attractive to many investors. The fact that they can be bought and sold throughout the day at a currently available price can be a better way of trading in the broad market than a normal index fund that is available only at day-end NAV. As time goes by, we’ll probably see more and more specialised ETFs which seek to fill in particular niches. While the Gold ETFs are the first of this kind, as and when funds for other high-liquidity commodities become possible, they are more likely than not to be ETFs. The mix of characteristics of stocks and funds that ETFs offer has some unbeatable advantages.
?The author is CEO, Value Research