on ETFs

This was published in Money Today magazine.

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How to invest in an exchange traded fund?
August 8, 2007

Question :

I don’t like the high entry loads and expense ratios of equity funds. How can I invest in exchange traded funds (ETFs)? What is the load structure and expense ratio of an ETF? Which ETF tracks Nifty 50? How can I invest in it?

— Sumant Sarkar, Bangalore

Answer :

How to Buy: As their name suggests, ETFs are traded on stock exchanges just like any listed share. You can buy an ETF if you have a trading account with a stock broker. You also need to have a demat account.

Load Structure: ETFs have lower entry load than equity mutual funds. The brokerage payable is around 0.5% (including commission, service tax and securities transaction tax). Equity mutual funds charge 2-2.5% entry load. But there is no exit load in open-ended mutual funds. In case of ETFs, you also have to pay brokerage when you sell the units, so the total load adds up to 1%.

Index Tracking and Pricing: ETFs track a stock index and invest in shares of that index in the same proportion. They are priced at a specified fraction of that index. For instance, the Banking BeES ETF is priced at 10% of the Bank Nifty level while the Nifty Benchmark ETS is priced at 10% of the S&P CNX Nifty. If the Bank Nifty is at 6838 level, the Banking BeES will be trading around Rs 683.80 per unit. Similarly, when the Nifty is at 4,200, units of the Nifty BeES will be traduing around Rs 420 each.

Recurring Expenses: Since they invest in a fixed basket of shares and do not require active management, ETFs have a lower expense ratio—the recurring annual charge for managing the fund—of about 0.3-1%. In comparison, actively managed equity funds have expense ratios of up to 2.5%.

Index Funds: A fund type that resembles ETFs is index funds. Like ETFs, index funds have low expense ratios. These funds track stock indices and invest in the same basket of shares. The entry load is about 2.5% and the expense ratio is about 1%. But index funds do not match benchmark returns so closely as do ETFs. In fact, they often underperform the benchmark.

Equity Funds: Of course, there is always the option of investing in equity funds. Well managed equity funds usually outperform the benchmark, thus justifying their high expense ratio. But they are more volatile than ETFs and index funds. If you are willing to take a little risk for higher potential returns, diversified equity funds are a better option.

Real Time Trading: ETFs can be traded at any time during trading hours. Equity fund and index fund transactions are recorded at the end of the day.