ETF's

Exchange Traded Funds

An ETF is an Exchange Traded Fund, which unlike regular Mutual Funds trades like a common stock on a stock exchange.

The units of an ETF are usually bought and sold through a registered broker of a recognised stock exchange. The units of an ETF are listed in stock exchanges and the NAV varies as per market movements. Since units of an ETF are listed in the stock exchange only, they are not bought and sold like any normal open end equity fund. An investor can buy as many units as she wishes without any restriction through the exchange.

In the simple terms, ETFs are funds that track indexes such as CNX Nifty or BSE Sensex, etc. When you buy shares/units of an ETF, you are buying shares/units.

In the simple terms, ETFs are funds that track indexes such as CNX Nifty or BSE Sensex, etc. When you buy shares/units of an ETF, you are buying shares/units of a portfolio that tracks the yield and return of its native index. The main difference between ETFs and other types of index funds is that ETFs don't try to outperform their corresponding index, but simply replicate the performance of the Index. They don't try to beat the market, they try to be the market.

ETFs typically have higher daily liquidity and lower fees than Mutual Fund schemes, making them an attractive alternative for individual investors.

Types of ETFs

There are various types of ETFs available to investors that can be used for income generation, speculation, price increases, and to hedge or partly offset risk in an investor's portfolio. Below are several examples of the types of ETFs.

• Bond ETFs might include government bonds, corporate bonds, and state and local bonds—called municipal bonds.
• Industry ETFs track a particular industry such as technology, banking, or the oil and gas sector.
• Commodity ETFs invest in commodities including crude oil or gold.
• Currency ETFs invest in foreign currencies such as the Euro or Canadian dollar.
• Inverse ETFs attempt to earn gains from stock declines by shorting stocks. Shorting is selling a stock, expecting a decline in value, and repurchasing it at a lower price.

Real World Examples of ETFs

Below are examples of popular ETFs on the market today. Some ETFs track an index of stocks creating a broad portfolio while others target specific industries.

• SPDR S&P 500 (SPY): The oldest surviving and most widely known ETF tracks the S&P 500 Index
• iShares Russell 2000 (IWM): Tracks the Russell 2000 small-cap index
• Invesco QQQ (QQQ): Indexes the Nasdaq 100, which typically contains technology stocks
• SPDR Dow Jones Industrial Average (DIA): Represents the 30 stocks of the Dow Jones Industrial Average
• Sector ETFs: Track individual industries such as oil (OIH), energy (XLE), financial services (XLF), REITs (IYR), Biotech (BBH)
• Commodity ETFs: Represent commodity markets including crude oil (USO) and natural gas (UNG)
• Physically-Backed ETFs: The SPDR Gold Shares (GLD) and iShares Silver Trust (SLV) hold physical gold and silver bullion in the fund

Advantages and Disadvantages of ETFs

ETFs provide lower average costs since it would be expensive for an investor to buy all the stocks held in an ETF portfolio individually. Investors only need to execute one transaction to buy and one transaction to sell, which leads to fewer broker commissions since there are only a few trades being done by investors. Brokers typically charge a commission for each trade. Some brokers even offer no-commission trading on certain low-cost ETFs reducing costs for investors even further.

An ETF's expense ratio is the cost to operate and manage the fund. ETFs typically have low expenses since they track an index. For example, if an ETF tracks the S&P 500 index, it might contain all 500 stocks from the S&P making it a passively-managed fund and less time-intensive. However, not all ETFs track an index in a passive manner.

Pros

·      Access to many stocks across various industries

·      Low expense ratios and fewer broker commissions.

·      Risk management through diversification

·      ETFs exist that focus on targeted industries

Cons

·      Actively-managed ETFs have higher fees

·      Single industry focus ETFs limit diversification

·      Lack of liquidity hinders transactions

Actively-Managed ETFs

There are also actively-managed ETFs, where portfolio managers are more involved in buying and selling shares of companies and changing the holdings within the fund. Typically, a more actively managed fund will have a higher expense ratio than passively-managed ETFs. It is important that investors determine how the fund is managed, whether it's actively or passively managed, the resulting expense ratio, and weigh the costs versus the rate of return to make sure it is worth holding.

Indexed-Stock ETFs

An indexed-stock ETF provides investors with the diversification of an index fund as well as the ability to sell short, buy on margin, and purchase as little as one share since there are no minimum deposit requirements. However, not all ETFs are equally diversified. Some may contain a heavy concentration in one industry, or a small group of stocks, or assets that are highly correlated to each other.

Dividends and ETFs

While ETFs provide investors with the ability to gain as stock prices rise and fall, they also benefit from companies that pay dividends. Dividends are a portion of earnings allocated or paid by companies to investors for holding their stock. ETF shareholders are entitled to a proportion of the profits, such as earned interest or dividends paid, and may get a residual value in case the fund is liquidated.

ETFs and Taxes

An ETF is more tax efficient than a mutual fund since most buying and selling occurs through an exchange and the ETF sponsor does not need to redeem shares each time an investor wishes to sell, or issue new shares each time an investor wishes to buy. Redeeming shares of a fund can trigger a tax liability so listing the shares on an exchange can keep tax costs lower. In the case of a mutual fund, each time an investor sells their shares they sell it back to the fund and incur a tax liability can be created that must be paid by the shareholders of the fund.

ETFs Market Impact

Since ETFs have become increasingly popular with investors, many new funds have been created resulting in low trading volumes for some of them. The result can lead to investors not being able to buy and sell shares of a low-volume ETF easily.

Concerns have surfaced about the influence of ETFs on the market and whether demand for these funds can inflate stock values and create fragile bubbles. Some ETFs rely on portfolio models that are untested in different market conditions and can lead to extreme inflows and outflows from the funds, which have a negative impact on market stability. Since the financial crisis, ETFs have played major roles in market flash-crashes and instability. Problems with ETFs were significant factors in the flash crashes and market declines in May 2010, August 2015, and February 2018.

History

ETFs had their genesis in 1989 with Index Participation Shares, an S&P 500 proxy that traded on the American Stock Exchange and the Philadelphia Stock Exchange. This product, however, was short-lived after a lawsuit by the Chicago Mercantile Exchange was successful in stopping sales in the United States.

A similar product, Toronto Index Participation Shares, started trading on the Toronto Stock Exchange (TSE) in 1990. The shares, which tracked the TSE 35 and later the TSE 100 indices, proved to be popular. The popularity of these products led the American Stock Exchange to try to develop something that would satisfy SEC regulation in the United States.

Nathan Most and Steven Bloom, under the direction of Ivers Riley, designed and developed Standard & Poor's Depositary Receipts (NYSE Arca: SPY), which were introduced in January 1993.[15][16] Known as SPDRs or "Spiders", the fund became the largest ETF in the world. In May 1995 they introduced the MidCap SPDRs (NYSE Arca: MDY).

Barclays Global Investors, a subsidiary of Barclays PLC, in conjunction with MSCI and as its underwriter, a Boston-based third party distributor, Funds Distributor Inc., entered the market in 1996 with World Equity Benchmark Shares (WEBS), which became iShares MSCI Index Fund Shares. WEBS tracked MSCI country indices, originally 17, of the funds' index provider, Morgan Stanley. WEBS were particularly innovative because they gave casual investors easy access to foreign markets. While SPDRs were organized as unit investment trusts, WEBS were set up as a mutual fund, the first of their kind.

In 1998, State Street Global Advisors introduced "Sector Spiders", which follow nine sectors of the S&P 500. Also in 1998, the "Dow Diamonds" (NYSE Arca: DIA) were introduced, tracking the famous Dow Jones Industrial Average. In 1999, the influential "cubes" (NASDAQ: QQQ), were launched attempting to replicate the movement of the NASDAQ-100.

In 2000, Barclays Global Investors put a significant effort behind the ETF marketplace, with a strong emphasis on education and distribution to reach long-term investors. The iShares line was launched in early 2000. Within five years iShares had surpassed the assets of any other ETF competitor in the U.S. and Europe. Barclays Global Investors was sold to BlackRock in 2009.

The Vanguard Group entered the market in 2001. The first fund was Vanguard Total Stock Market ETF (NYSE Arca: VTI), which has become quite popular, and they made the Vanguard Extended Market Index ETF (NYSE Arca: VXF). Some of Vanguard's ETFs are a share class of an existing mutual fund.

iShares made the first bond funds in July 2002, based on US Treasury bonds and corporate bonds, such as iShares iBoxx $ Invst Grade Crp Bond (NYSE Arca: LQD). They also created a TIPS fund. In 2007, they introduced funds based on junk and muni bonds; about the same time State Street and Vanguard created several of their own bond ETFs.

Since then ETFs have proliferated, tailored to an increasingly specific array of regions, sectors, commodities, bonds, futures, and other asset classes. As of January 2014, there were over 1,500 ETFs traded in the U.S., with over $1.7 trillion in assets.[20] In December 2014, U.S. ETF assets went above $2 trillion.[21]

CPSE ETF is an exchange-traded fund that invests in 12 state-owned companies that are a part of the Nifty CPSE index. It runs a concentrated portfolio with a handful of stocks having weights as high as 20 per cent on the underlying index. The portfolio is concentrated towards the energy and oil sector. The units of ETF can be traded like a stock on exchanges. It has invested in the shares of BHEL, Coal India, NBCC, NLC India, NTPC, Oil India, ONGC, SJVN, Cochin Shipyard, NHPC, NMDC and Power Grid

Through the earlier six tranches of the CPSE ETF, the government has already raised about Rs 50,000 crore.

Bharat Bond ETF, India's first-ever corporate bond exchange traded fund with a fixed maturity of 3 years and 10 years, about fetched ₹12,400 crore from its debut offer.

The assets under management (AUM) of passively managed funds have crossed the ₹1 lakh crore mark. While most of the funds continue to come from the mandatory contribution to the Employee Provident Funds Organisation (EPFO), financial planners point out that an increasing number of HNIs and retail investors have started pouring money into index funds and ETFs as actively managed funds in the large-cap space have failed to outperform their benchmarks.

As per data, only 2 out of 32 large-cap funds could outperform their benchmark indices over the last one year. Given this, many financial planners have started recommending index funds or exchange traded funds as a substitute to large cap funds, and this shift is likely to accelerate in the coming days. Also chasing funds with Alpha is difficult as they change every year and very few are consistent.

From the first ETF launched in India in December 2001 that was benchmarked to Nifty50, today there are 71 ETFs benchmarked to various equity and debt indices with total asset under management of ~ Rs1.47tn.

Globally, the total asset under management across ~7797 ETFs/ETPs has crossed $5.78tn as on Sep 30, 2019. ETF AUM is dominated by US (70% market share), followed by Europe (16%) & Asia Pacific (11%). Equity ETFs account for 76%, followed by Fixed Income at 20% and Commodity & Others at 4%.

As compared to Index Funds, ETFs have lower fees, are exchange tradeable and provide real time rates. In India ETFs can be held in demat mode only and traded through brokers on the stock exchange. Index Funds are open ended funds like Mutual Funds with lower fees and replicate the index. They are available in physical and demat mode.