Exchange traded funds can provide flexibility, better price transparency

A common phenomenon of human nature is to aim for more gain with less pain. But life is other way round and so is true for the investments. The well-known rule of investment is that the return commensurate with risk. Traditionally the investors are risk averse, they prefer less risk to high risk. On the other hand, they will prefer higher returns too.

So, what should one do? The higher returns are available with direct equity and equity mutual funds (MF) which have higher risk too. These investments are important for wealth creation so they can't be ignored. Here comes the solution, a product which has relatively less risky being an equity product and gives the market return. They are index mutual fund (IMF) and the exchange traded fund (ETF) which are passively managed funds and the portfolio of which mirrors a market index. The IMF's and ETF's minimum investment should be at 95% of total assets in the same stocks that composites the Benchmark Index they follow. For example, a Nifty Index Fund will invest predominately in the securities that are part of Nifty. The difference is ETFs are traded on a stock exchange like a stock.

The total size of ETF in India stands at Rs 1430 bn which is 5.5% of total mutual fund AUM (at Rs 25,940 bn) as on May 2019. Of this, equity ETF stands at Rs 1370 bn (5.3% of total AUM) and Gold ETF stands at Rs 46 bn (0.2% of total AUM). In comparison with this, the IMFs are at Rs 56 bn (0.2% of total AUM). Still, when compared to the Global ETF market which stood at USD 4.7 trn (as per statista.com as in 2018), the Indian ETF market is just 4% of it.

Now let's look at the key advantages of ETF over the IMF. The ETF provides more flexibility in trading and better price transparency. Since ETFs are exchange listed, one can trade at any time and any number of times during the market hours. The continuous price mechanism of ETF makes the price trading near its NAV and the investors are getting several real time price levels for entry and/or exit points depending on his/her preference. On the other hand, IMF can be bought and redeemed normally once in a day and the NAV is not known till the end of the day. The operating expenses of ETF are also lower than that of IMF. The portfolio disclosure is also on a daily basis as compared to monthly disclosures in the case of IMF. Of course, being listed, one needs to have a demat account for trading in ETF while it is optional for the IMF.

Coming to types of ETF, the most famous are equity ETF and within that, the most popular are the benchmark index fund (Nifty, Sensex). There are ETF available of large-cap index, bank index, mid-cap index, also.

The next most popular ETF is that of Gold. Gold funds invest predominantly in physical gold or gold-related investments. One point to keep in mind is that the returns for these investments will depend on the price movement of physical gold in the international markets. An appreciating domestic currency can lower the returns of these funds as the prices of gold internationally are priced in US Dollars. The advantage is that it provides a safer option since there are no risks of theft or quality and they also provide liquidity and ease of transaction.

Now let's look at the process of investment in ETF. As mentioned earlier, one needs to open a demat and a trading account first. Then one should select the asset class, say equity or gold and the appropriate scheme within it. The return for the same class of funds would be similar, so there are other factors one needs to watch out for. To start with look for the size of the fund and the trading volume of these ETFs. One with the relatively high trading volume will provide a lower bid-ask spread. Bid-ask spread is the difference between the price that an investor pays to buy the ETF (ask) and the price at which he/she sells (bid). The next factors are the expenses ratio and tracking error. The tracking error, in simpler terms, is the percentage by which the return of ETF is different from that of Index. After critically evaluating these criteria, one should select the fund matching his/her return expectation and risk appetite.

Please remember that instead of looking at IMF and ETF as alternatives, look at them as complementary to each other. Both are important for meeting financial goals including wealth creation and retirement planning. Just keep investing regularly, just like a SIP and diversify the portfolio slowly but definitely. So go ahead, jump and ride the growth of different asset classes with ETF! And always remember ETF is (E)asy (T)echnique of creating (F)ortune! Of course, advise of professionals would be advised.

The writer is CFA, head of department and asst professor, Financial markets ITM Business School