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What is ETF and how do they work?

An ETF or exchange-traded fund is a type of investment fund that can be bought and sold on stock markets. 

Mutual fund companies made 18 exchange-traded funds (ETFs) this year. They range from those that invest abroad to those that use factors, as well as those that focus on specific sectors or themes. These funds are called "ETFs." However, many people aren't sure if they should invest in an ETF or a stock fund.



How are ETFs different from index funds?

Index funds and ETFs are both passive funds. Neither fund seeks to outperform nor underperform their respective benchmark indices. Like an index fund, an ETF picks a benchmark index and tries to match its performance. That's all there is to it.

Just like stocks, ETFs are only available on the stock exchange. Index funds strive to match an underlying index's performance. However, investors are not offered intraday buying or selling prices. Each day's NAVs are announced. The Securities and Exchange Board of India's new rules states that an investor can only get that day's NAV while investing in the fund. A few days or perhaps weeks may pass depending on your investment method and duration. However, ETFs are traded like stocks, so investors can buy or sell them at any time

Why are ETF tracking errors typically lower than that of index funds?

An ETF's structure is regarded to be better than an index fund's. An index fund is similar to a mutual fund. When investors buy the fund, it buys the underlying assets in a way that closely matches the index fund. The fund manager has cash. The bigger the cash component, the worse the scheme's performance. Despite the index fund manager's best efforts, money is not always distributed instantly. This causes a tracking error.

A fund company can only generate an ETF unit by swapping a basket of securities. The ingredients of a unit basket are fixed; typically, underlying securities and a small amount of cash. So an ETF's cash component is kept under control, reducing tracking inaccuracy.

Yes, large investors can trade directly with the fund house, but only if the basket is accurate.

Who creates the ETF liquidity on the stock exchange, then?

Market makers play a significant part in the life cycle of an ETF here. To create liquidity on the stock exchanges, fund houses appoint market makers for each of their ETFs. Individual brokers generate (and destroy) units directly with the fund house so that regular investors can buy and sell them on the exchange easily and anytime they wish.


Intraday NAVs (iNAVs) is also published by ETFs, which are updated by MFs throughout the trading session. The iNAV is the ETF’s current value, calculated from the value of the index’s holdings.

That means an ETF is a winner. Can we just dump all our index funds and switch to ETFs, now?

Not exactly. An exchange-traded fund (ETF) can be more expensive than an index fund. Because ETFs may only be purchased and sold on stock exchanges, you’ll need a Demat account (charges are Rs 300-450 per annum). (These fees are often waived for active investors or traders.) Brokerage fees are also charged; most charge up to 0.5 percent every trade. Discount brokers don’t impose fees if you take delivery of an ETF (rather than trading it for a day or two).

ETFs with low market volumes lack liquidity since you may not be able to find enough buyers to sell your shares or enough sellers to buy some units, resulting in impact costs for investors. The impact cost is the difference between the price you actually pay and the scheme’s NAV. On the National Stock Exchange, for example, the impact cost for Nippon India ETF Nifty BeES was 0.03 percent (December 17, 2021).

How to measure an ETF’s performance?

Passive funds are best measured by their tracking errors or the deviations in their performance from their respective benchmark indices. Over the years, as fund houses and markets have matured, tracking errors of passive funds, especially index funds, have shrunk.

The tracking errors or variances in performance from their respective benchmark indexes are the best indicators of passive funds’ success. Tracking mistakes of passive funds, particularly index funds, have decreased over time as fund houses and markets have matured.

However, there are other reasons for tracking inaccuracies. Stock prices can be erratic when the underlying constituents of an index fluctuate. On days like these, it’s also tough to replicate the index.

Lack of liquidity in the underlying index’s stocks contributes to tracking error by causing high impact costs when buying and selling. As a result, the tracking error of a small-cap and mid-cap passive fund is often larger than that of a large-cap fund.

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