Much like packaged foods, exchange traded funds (ETFs) have their merits and demerits. They offer the convenience of “ready-to-serve investments” at a price of finger chips, but may not fully meet your expectations if you have exotic tastes. For those who believe in just taking a bite without putting their fingers in a pie, however, ETFs offer a perfect investment strategy.
Johnny: Tell me, Jinny, what are ETFs?
Jinny: ETFs are close cousins of mutual funds. In many respects, ETFs work like mutual funds. For instance, an ETF may provide you an opportunity to invest in a basket of stocks that reflects an index just like an index-based mutual fund, or you may find an ETF that represents a basket of stocks consisting of a particular sector just like a sector-specific mutual fund, or an ETF based on a specific commodity such as gold just like any gold-oriented mutual fund. You can make investments in an ETF by buying shares of that particular ETF, which gives you an opportunity to make an indirect investment in the basket of stocks or commodities constituting that particular ETF.
But, you may ask, why is it called indirect? That’s because you do not directly own stocks of any company. You just own shares of the ETF which, in turn, holds shares of different companies as your trustee. Investment in just one share of an ETF can give you exposure to an index or a particular sector. So, if you are investing in a share of an ETF representing a stock market index, then your return would depend upon the rise or fall of that particular index. Similarly, if you are investing in a share of an ETF representing gold, then your return would depend upon the rise or fall in the price of gold. You should keep in mind that investments in ETFs, in many respects, look like investments in mutual funds but, despite many similarities, ETFs and mutual funds are not one and the same thing.
Illustration: Jayachandran / Mint
Johnny: Tell me, Jinny, in what ways are they different?
Jinny: Mutual funds offer either open-end or closed-end schemes. ETFs differ from both open-end and closed-end mutual funds in many ways. For example, the shares of ETFs are listed on the stock exchanges, which you can trade at any time, just like any other stock. But the units of open-end mutual funds are not listed on the stock exchanges. Such units can only be redeemed at the end of the day at their net asset value, or NAV, as disclosed by the mutual fund.
Johnny: But what about closed-end funds? Their units are listed on stock exchanges.
Jinny: That’s true, but even closed-end schemes lack many other advantages of ETFs. For instance, you can buy ETF shares on margin or short-sell them just like any other stock to take advantage of intraday movements in the market, but you can’t buy the units of closed-end schemes on margin, nor can you take advantage of intraday changes in their NAV by short selling the units. Further, the prices of ETF shares keep changing in line with the underlying stocks or commodities represented by that particular ETF.
So ETF shares are, in many ways, traded like any other stock listed on stock exchanges. But closed-end funds sometimes trade at a premium to their present NAV and sometimes they trade at a discount, which means that the trading prices may not be fully aligned with their actual worth. Shares of ETFs, however, trade at a price closer to the price of stocks or commodities represented by them.
Johnny: Are there more differences?
Jinny: Yes, a final one. ETFs differ from mutual funds in terms of their cost. To buy or sell shares of ETFs, you need to pay the fee to your broker just as you would for any other stock, whereas both closed- and open-end mutual funds charge various other expenses. The asset management fee for ETFs is typically less due to their unique structure. So, making investments through ETFs may cost you less than making investments through mutual funds. But keep in mind that the more frequently you trade the shares of ETFs, the more you end up paying in fees. I should add one more caveat here: There are several other factors you should carefully evaluate before deciding to choose between ETFs and mutual funds.
Johnny: We can talk about the caveats some other time. I would be happy if you could explain the unique structure of ETFs next week.
What: ETFs provide opportunities for indirect investments in a basket of stocks or a commodity
How: The shares of ETFs represent fractional interest in a basket of stocks or a commodity which that particular ETF holds as a trustee
Why: ETFs are becoming popular because they can be traded like stocks at a lower transaction cost while retaining most of the benefits of mutual funds
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org