The Hindu Business Line : What is an ETF?

Exchange Traded Fund (ETF) is an open-ended fund that can be traded like a share on a stock exchange. It is also an index-tracking collective investment fund that aims to track the performance of the underlying index by holding a portfolio of the constituent stocks of that index.

ETFs invest in a portfolio of securities, which may include international shares, fixed income securities, listed property trusts, or a combination of asset classes. Prices therefore are determined by the value of the assets the ETF holds.

As investors move in and out of ETFs, the fund issues new units or cancels them accordingly. This allows them to maintain on-market prices that correlate closely with the value of the underlying portfolio.

Types of ETFs

ETFs can be broadly classified as Indexed ETFs and Actively managed ETFs.

Indexed ETFs: Indexed ETFs (sometimes referred to as Classical ETFs) typically offer low management fees, since they have a low operating cost structure. Reasons for the low cost structure are as follows:

The fund manager does not have to exercise a high level of administration, as investors wanting to buy or sell units can only do so on a particular index (such as the S&P/ASX 200)

The turnover of underlying shares in the portfolio is minimal as the fund tracks a share market index. In addition, once the target investment portfolio is established, there is no ongoing need for the ETF manager to undertake research, since the portfolio composition is determined by the index.

Actively Managed ETFs: Actively managed ETFs provide access to a much broader range of investment management styles, strategies, asset classes and operational practices than indexed ETFs.

Additionally, actively managed ETFs can usually accept cash applications, which means investors can buy units directly from the fund manager through lodging an application form contained in the fund prospectus as well as to buy units already issued on that index.

Key benefits

Diversification: An ETF represents an investment portfolio, which provides diversified exposure to an asset class through a single investment.

Global exposure: Some ETFs invest in a pool of overseas securities, offering investors exposure to a foreign market.

Trades like a share: ETF units are traded like shares listed on a stock exchange. Moreover, market makers may be designated to promote the liquidity of ETF units.

Low transaction costs: ETFs, in general have lower transaction costs than traditional open-ended investment funds. The transaction costs of trading an ETF are similar to those of trading stocks, including brokerage and other relevant fees and expenses payable for dealing through the stock exchange.

Information Dissemination: ETFs being exchange-listed instruments, need to comply with the information disclosure requirements of the relevant stock exchanges. The level of the index and the constituent stocks which make up the index are publicly available information that investors can easily access. Price quotations of ETF units for potential buyers and sellers are available even during exchange trading hours.

The Risks

The performance of ETFs that track a concentrated/sector index could be more volatile than the performance of diversified funds.

Like other index-tracking funds, ETF is not actively managed, meaning that the fund manager does not have the discretion to select stocks or secure defensive positions in declining markets. Hence, any fall in the underlying index will result in a corresponding fall in the value of the ETF.

There is no assurance that the performance of the ETF will be identical to the performance of the underlying index due to factors such as tracking errors.

Although listed on a stock exchange, ETFs face the risk of not being actively traded.

The market price of the ETF unit could be higher or lower than its NAV per unit due to market demand and supply and liquidity.

(Sourced from ICICI Bank’s Investment Review Half-Yearly Edition 2007)

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