ETFs: Myths and Merits

ETFs as an investment product were introduced in US in 1993 and have garnered a good amount of attention in the last decade. In India, we have seen a stream of ETF launches by several fund houses to catch on the hype.  ETFs are basically open-ended index funds listed on stock exchanges but, do ETFs really make sense for retail investors? If yes, what are the pros and cons?

Advantages of ETFs

� ETFs allow diversification into companies or assets or themes
� They are traded real time
� ETFs are inexpensive. The expenses are annual varying from 0.05% and 1.60%.
� The portfolio composition of ETFs will be available to investors on a daily basis and is transparent

Myth: ETFs are easily trade-able

Reality: They can be easily bought or sold during the market hours, which means that the prices change throughout the day as determined by the market forces.

But, ETFs do not sell individual shares directly to investors and only issue their shares in large blocks (blocks of 50,000 shares, for example) that are known as "Creation Units" (source: Securities Exchange Commission). Investors can sell their ETF shares in the secondary market, or sell the Creation Units back to the ETF. Hence, it may be difficult to exit a thinly traded ETF.

Myth: ETFs are same as mutual funds 

Reality: Unlike mutual funds, ETFs are not managed by professional fund managers nor do they have a specified mandate based on which allocation to a security is made. Also, ETFs can be purchased on margin and are lendable.

ETFs work for institutional investors as an alternative to futures by establishing a short or a long position in the market. During bear markets, the most profitable investment strategy would be to short the market. However, retail investors of mutual funds would find it hard to benefit from bear markets as most of the equity funds provide long only exposure - meaning investors would only benefit when the equity markets rise.

Thus, ETFs are for a sophisticated investor with risk appetite for a commodity or sector ETF whereas mutual funds are an investment product for the novice investor.

Myth: ETFs are actively managed investments

Reality: They form a passive form of investing and merely reflect the performance of the underlying units.

Conclusion

ETFs allow investors to expand their scope of investment into specific asset classes, sectors or countries. In India, we have however limited range of ETFs; most ETFs have exposure to Banks, Gold and benchmark indices.

In terms of size, volume and diversification, we are still a long way to go. Despite this, the recent rise in prices of Gold have resulted good inflows into Gold ETFs.

Easy information, mechanism to track ETFs and awareness about ETFs as an investment vehicle for portfolio diversification should result better inflows in future.