ETF - BUY THE ENTIRE MARKETS

Ever owned a stock or fund that seemed glued to its place even as the entire market was racing ahead? If you've had that experience, why not consider exchange traded funds (ETFs)? ETFs are good investment options simply because they faithfully track the index or asset they promise to track.

Owning a Nifty ETF would have given you the same 80 per cent return the Nifty index did in 2009. And if you were lucky enough to buy the ETF tracking the Junior Nifty a year ago, you would be sitting pretty on a gain of 146 per cent! How many stocks would have managed that? Buying an ETF is a sure-fire way to buy the market or a certain section of it, without selecting stocks, poring over balance sheets or complicated ratios.

ETFs are also a good way to own investments you cannot track on your own. Want to buy real estate in Hong King, Brazilian stocks or platinum? ETFs tracking those assets offer a ready solution; the reason why ETFs are today one of the largest classes of mutual funds, managing a whopping $1000 billion in assets.

How they work

But wait, what are ETFs? ETFs are closed-end mutual funds whose units are listed and traded on the stock exchanges like shares.

The objective of an ETF is neither to do better than the index or asset it tracks nor worse. Instead, an ETF simply tries to minimise “tracking error”— the difference between the fund's returns and that of the index or asset. The manager of an index ETF cannot make wild bets on stocks that will zoom ahead of the market (nor thankfully, ones that keep your adrenaline pumping by sinking to a fraction of their value)! Instead, the ETF's job is to replicate its index to its minutest detail. A Nifty ETF will own the basket of Nifty stocks in exactly the same proportion as the index itself.

As a retail investor, you can buy or sell ETF units on the stock exchanges where they are listed and traded. All you need is a trading account with your broker and the same demat account that you use for stocks.

Shadowing the index

How do ETFs manage to shadow the index so closely, when many other equity funds don't? First, by owning a portfolio that is a carbon copy of the index. This ensures that every stock price move that affects the index also affects the ETF the same way. If the big bosses at the NSE decide to tweak the Nifty index by adding a few stocks and removing others, the managers of Nifty ETFs too will do exactly the same to their portfolios.

Two, ETFs also have other inbuilt checks to ensure that their market price doesn't stray too far away from their underlying value. Small investors can only buy ETF units on the stock exchanges. But large ones (read institutions) have the option of buying chunks of an ETF in the form of “creation units”, by tendering shares or the underlying asset, in kind. The constant barter of physical assets for an ETF's units ensures that the fund's price doesn't stray too far away from the asset it reflects.

Why buy

Okay, ETFs save me the trouble of picking and choosing between stocks or funds. But are there any other benefits to them? Sure, there are. One, they allow you to buy costly assets or an entire basket of stocks in bite-sized portions.

Today, if you wanted to even loosely replicate the Nifty index by buying all its stocks, you would have to shell out nearly Rs 2.3 lakh. Whereas you can buy one unit of a Nifty ETF for just Rs 520, one-tenth of the day's Nifty value.

Two, among the various mutual fund options, ETFs are the cheapest to own. Open-end equity funds usually charge you about 2.25 per cent a year for managing and running the fund, which comes out of your own returns. An ETF comes at a much lower 0.50 per cent yearly charge (you would however incur brokerage on buying units).

Believe us, that can make a material difference to your long-term returns. You also don't run the risk of your fund manager holding a lot of cash and missing the bus!

Three, ease of transaction. As ETFs can be bought through your online stock trading account, you needn't set up a separate account with a fund house or find a separate advisor to buy or sell ETF units. You can also buy or sell ETF units intra-day, not possible with open-end funds.

Know your options

Okay, you're convinced about ETFs and want to take the plunge. Here's what you need to know now:

#1. Decide on the asset or index you'd like to own. The Indian stock exchanges allow trading in as many as 18 different ETF products.

On the menu are:

Six Gold ETFs (from Benchmark, Kotak, UTI, Quantum, Reliance and SBI Funds), mostly one unit representing one gram of gold.

Three Nifty tracking ETFs — Nifty BeEs, UTI SUNDER and QNifty — representing one-tenth of the Nifty value. Kotak Mutual Fund has also launched its own Kotak Nifty ETF this week.

Two Sensex tracking ETFs — ICICI Pru SPICE and Kotak Sensex ETF.

Specialised products that track the Junior Nifty, CNX banking index, PSU banking index and liquid funds.

#2. Compare trading volumes between ETFs and go for the most traded one. ETFs in the Indian context may feature low trading volumes.

That can impair your ability to sell your units when you choose. They can also lead to sharp intra-day blips in quoted prices of ETFs, impacting your returns.

#3. Check the latest NAV of the ETF (from the announcements section) before punching in your trade. The NAV is the true value of the ETF unit that you are buying and you shouldn't pay market prices that aren't close to the NAV.