Exchange Traded Funds or ETFs-How do they work - ArthikDisha (2024)

The way the mutual fund industry is performing for the last 4 to 5 years, it is very likely that the investors would also like to explore various mutual funds products. This is my belief that the recent growth story of India is not temporary but a perpetual one and thus the mindset of investors in relation to shifting their focus from fixed interest earning products towards equity and equity related instruments are going to stay for decades as well. Considering this, today I have decided to write a blog post on Exchange Traded Funds or ETFs -How do they work? This is a different kind of mutual funds of traditional nature.

What are Exchange Traded Funds or ETFs?

The name itself suggests that this fund is being traded in the recognized stock exchanges like stocks or shares. So, this is a little bit different from mutual funds in this aspect.

Exchange Traded Funds primarily invest in a portfolio of securities that replicates an index or underlying assets. This means ETF primarily does invest and follow the price movements of underlying assets such as different commodities, precious metals like gold, stocks, currencies, and options. ETFs track the indices likeNifty and Sensex.So, one can say that this is a kind of hybrid investment vehicle having the characteristics of both index fund and mutual fund. Unlike mutual funds, ETFs carry a lower expense ratio since this fund is not actively managed.

How do Exchange Traded Funds work?

Since Exchange Traded Funds directly invest in underlying assets or index, the risks and return are also linked directly to the performance of the underlying assets. Most importantly, ETFs are listed and traded like stocks and provide more flexibility, unlike traditional mutual funds. Their value changes on a real-time basis with the change in the underlying assets.

ETF offers individual investors the flexibility of buying and selling the units from a stock exchange in real-time basis unlike the closing day NAV for open-ended mutual funds.

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One can transact in ETFs on a real-time basis like stocks and it is transacted at the instant price shown by the stock exchange. Also, the units are allotted instantly based on the available price and transacted amount.

The transaction is done on a stock exchange through trading portals or stock brokers. Also, to transact in the ETFs you must have a DEMAT account.

Therefore, I can say that Exchange Traded Funds help an investor in taking advantage of the intraday price movements and hedge their long position in the equity market. Generally, ETFs are cheaper than index funds.

Difference between ETF and Mutual Fund

Though ETFs are kind of mutual funds but these two have got some differences as well. Let’s see the key differences.

Whatare thetypes of Exchange Traded Funds or ETFs?

Gold ETFs:A Gold ETF is an Exchange Traded Fund that tracks the price movement of gold.An ETF that primarily invests in gold producing company or gold bullion are called as Gold ETFs. So, for a gold ETF, the share price must necessarily reflect the spot price of the underlying asset which is gold. This means the gold ETF’s performance will be dependent on the price movements of the gold in the market.

Each ETF unit basically represents one gram of gold. For every unit of ETF issued the fund holds gold in the physical form of 99.5% purity. This fund is also allowed to invest in the gold deposits schemes of banks subject to a maximum of 20% of the net assets of the scheme.

Most importantly, the custodian of the fund is responsible for the safeguarding of the assets. The actual returns from this gold ETF may be a little bit lower from that of the market return from the gold due to its expense ratio and cash holdings. The main benefit of this ETF is that investors are holding the equal value of golds not physically but on the paper basis and thus get rid of the risks of holding huge gold at home.

Commodity ETF:ETF that invests primarily in physical commodities such as natural resources, agricultural goods, and metals are called commodity ETFs. A commodity ETF can work in two ways such as either;

a)it may focus on a single commodity and holds it in physical storage or may invest in futures contracts. or

b)it forms an index that includes dozens of commodities with a combination of physical storage or futures contracts.

In recent times, commodity ETFs have gained popularity due to the investors’ exposures to various commodities without the needs of learning various complex things regarding futures or derivative options.

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What is an ETF Index fund?

An ETF index fund is a kind of mutual fund that tracks a specific market i.e. Index like Sensex or Nifty. It is a very low-cost investment vehicle. Index Fund is a mutual fund slightly different from ETF in regards to their transaction patterns like trading and pricing.

Like in the case of Index ETF, one can invest at any time but the transaction price would be decided on the basis of closing day’s NAV. But in case of only ETF one can invest at the real-time quoted price in the stock market.

ETFs are Traded in the stock exchange like other stocks. Whereas one can buy ETF indexed funds from the Asset Management Company like regular mutual funds. Both of these have got some expense ratios for running the funds but Index ETFs expense ratio is slightly higher than plain ETFs.

Like ETF, Index ETF is also passively managed fund, since there is nothing so much to do, only rebalancing is required since it only follows the price movements of securities directly related to underlying assets, unlike regular mutual funds.

ETF Index fund is suitable for long-term investors who really want to create wealth for long-term and do not want to hedge their future positions from market downturns.

Most advantageously to transact an Index ETF you only need a Bank Account and you must be KYC compliant. On the other hand for investment in Exchange Traded Funds, you must need a DEMAT account.