Exchange Traded Funds (ETF) Definition
An Exchange Traded Fund (ETF) is defined as a basket of stocks traded on the stock exchange reflecting the position of a stock index like the S&P 500 or BSE Sensex. The trading value of the same is based on the NAV of the underlying stock it represents. They bring in the best of both Open-end and Close-end funds. They provide instant diversification just like Open-end funds and can be traded throughout the day just like closed-end funds. The advantage of all-day tradable funds is that investors can utilize combinations of Limit orders, stop orders and even short sell is allowed in some cases.
Example of Exchange-traded funds includes SPDR S&P 500 (NYSE Arca|SPY), iShares Russell 1000 Index (NYSE Arca|IWB), Vanguard S&P 500 (NYSE Arca|VOO), etc.
Types of Exchange Traded Funds (ETF)
Basis the underlying portfolio, Exchange traded funds can be classified in six broad categories. types of exchange-traded funds are:
#1 – Equity Funds
Equity funds can be further classified as Large Cap, Small Cap, etc., Sector Specific funds, Index Funds, etc. As the name suggests, the underlying in these funds is equity. The investor gets the advantage of diversified investment with a small capital investment rather than buying individual shares of each entity which will cost more.
#2 – Fixed Income Funds
These funds offer lesser volatility, hence providing some degree of assured returns. The reduced volatility comes at the cost of lower returns. Typically, investors prefer to have 30 % to 40 % of their investments in Fixed income funds. But this number may vary basis the risk profile of the investor.
#3 – Commodity Funds
While diversifying the investment, one important thing to consider is the Correlation between the instruments. Commodity funds provide just that. Historically it has been observed, there is a negative correlation between US equity/bond market and commodity market, i.e., when the dollar value of equity / fixed income instruments falls, there is an upward push observed in commodities like Gold, Silver, etc. The Commodity funds provide exposure in such commodities without actually buying individual units of high-priced commodities.
#4 – Currency Funds
One of the main purposes of investing in currencies is to provide a hedge to exposure in local currency. Example, having exposure in GBP may provide gains when Dollar depreciates in global markets. Currency funds thereby provide a cheaper means to have such kind of exposure.
#5 – Real Estate Funds
These funds are more volatile than fixed income funds but are more attractive as these funds are liable to provide ninety percent of the income to Fund holders, thereby generating better returns while assuming slightly more volatility.
#6 – Special Funds
Foreign Markets fund, Derivative funds, Inverse ETFs, leveraged funds are other complex structured funds which are sought by investors having specific requirements. Although, little less liquid then the conventional ETFs, these funds are held by Corporates to hedge exposure/ invest in markets specific to their business.
ETF NAV Calculations and Trading
Net Asset Value of exchange-traded funds has a bit different interpretation from a usual Mutual Fund. Although, both are calculated at the end of a trading day (typically at 4 PM). The Mutual Funds are bought / Sold at NAV whereas ETFs may trade at a different price than NAV. The trading price may be slightly different from the NAV. Still, NAV calculations are important for the following two purposes:
- It gives an indicative direction of Fund (whether it is Over or Under priced).
- The Closing NAV can be used for Mark to market purpose.
NAV is calculated as:
Consider an ETF Owns $5 billion in Equities, $2 billion in Bonds and keeps $1 billion in Cash. It owes $2 billion in the form of management and exchange fees. Outstanding units be 500 Million.
Calculation of NAV can be done as follows –
- NAV = $ (5 + 2 + 1) – (2) / o.5
- NAV = $ 12
However, the Price (which keeps on changing throughout the day) on the exchange may be 11.97 / 12.02 depending on the forces of demand and supply. But, such difference from NAV is quickly nullified by the smart traders who keep track of such anomalies.
Advantages of Exchange Traded Fund (ETF)
Following are the advantage of the exchange-traded fund.
- Low Expense Ratio: Most of the ETFs are Passive funds i.e. these funds mimic the performance of indexes. This results in lower expense ratio i.e. lower fund management cost, sales and distribution costs.
- Taxes: Buy/ Sell transactions by ETF fund house are very few, as these are majorly passive funds. Hence, lesser transaction tax. Also, ETFs result in lower capital gains, hence the lower capital gains taxes.
- Traded All Day: Exchange traded funds are traded throughout the day, hence providing day trading opportunities for a scalp trader and bringing in all the possible combinations of Stop orders, limit orders, etc.
Disadvantages of Exchange Traded Fund (ETF)
Following are the disadvantage of the exchange-traded fund.
- Expensive: If diversification is not the priority, the cost of investing in ETFs will be noticeably higher than investing directly in stocks. As ETFs incur some management fees howsoever small, they may be.
- Diversification: Although, investment is diversified when compared to cherry picking the stocks to invest. ETFs are less diversified when compared to mutual funds.
- Taxes: The Capital gains are not uniformly low, certain funds have higher Capital gains tax because Treasury bonds transactions are subject to taxes. Also, to meet certain benchmarks there may be more than the usual number of transactions, resulting in transaction taxes.
Important Points
Major points to be noted from previous sections:
- Although traded all day, price is close to NAV, unlike the closed-end funds.
- ETFs may have attached Call/ Put options.
- ETFs are majorly passive managed funds, but with increasing volume in financial markets and rising competitions has led to the emergence of actively managed funds.
- ETFs have to disclose their holdings twice each day, thereby, providing better visibility for investors.
- ETFs have a low internal expense ratio.
- ETFs are regulated by the Securities and Exchange Commission (SEC).
Conclusion
ETFs are used by investors who want exposure in certain sectors/ industries. They do have certain advantages over Mutual funds and may be attractive for investors with the shorter horizon and who implement scalp trading strategies because of all day trading window. But, the disadvantages like limited diversification and little to zero alpha over index may keep long term investors away from the index funds. In the end, the decision about whether to invest in ETFs depends on what kind of exposure an investor is looking in.
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