ETFs

Introduction

I love ETFs. They are my preferred financial instruments of choice. And within ETFs, I prefer index funds. I prefer purchasing ETFs via SIPs - both ICICI and HDFC trading accounts allow that for a pretty small fee.

Terminology

• ETF: ETF is short for Exchange Traded Funds. These are just like mutual funds with one major advantage - in mutual funds, you can only sell back the units to the fund. In ETFs, these units can be bought and sold in the market just like any other stocks. Further derivatives (options and futures) on ETFs are also available and can be bought or sold.
• Active strategy: An active strategy tries to increase returns by trying to time the market - basically buy when the market is low and sell when it is high.
• Passive strategy: A passive strategy is a simple buy and hold. A basket of shares is created and then it is held for a long time (often several years) without any changes.
• Index: An index (like the BSE Sensex or the NSE Nifty) is basically a basket of stocks in a certain ratio. The index value is basically an average of the prices of the stocks weighted by the ratio in the basket.
• Index funds: These are mutual funds that track a certain index. In the best case, they purchase stocks in the same ratio as the index. Often, however, they purchase a subset of the stocks in a different ratio but these are so chosen to closely monitor the index.
• SIP / SEP: A SIP is a systematic investment plan while a SEP is a systematic equity plan. Basically these involve buying a small amount of stocks of units every few days (or every month) rather than all at once.

My reason for preferring ETFs are that they combine high returns with low hassle and good liquidity. Readers of my earlier post on liquidity will understand why it is so important. Unfortunately, it is very difficult to combine liquidity with high yields. Index fund ETFs are the closest that we get to the ideal.

Returns

First, let us look at returns. Elementary finance teaches us that the best risk-return ratio belongs to index funds - basically nobody can beat the market. Why that is so is the subject of another blog post but take it as gospel for now. This gives us the following rules of thumb

1. Mutual funds are better than individual stock.
2. Market index funds (like Nifty) are better than sectoral funds.
3. Passive strategy is better than active strategy.

The first is obvious since individual stock prices vary very much and so are risky. The second is a simple corollary. The third is surprising because EVERY mutual fund will say the opposite. What they do not tell you is that the charge for active strategy are high than for passive strategy so they have a vested interest in be-fooling you.

My preferred ETF - the NiftyBees (by Goldman Sachs) has an annual charge of only 0.5%. By contrast most mutual funds charge between 1-2%. Over a 20 year period, this itself will result in a 12-40% difference in returns.

Liquidity

Since ETFs can be traded, you can sell them via a trading account and get the money in 2 days. Hence, in case of an emergency, you will have cash in 3-5 days. Further, since they are index funds, you will not lose significantly due to market volatility.

Hassles

If you have a demat account, a trading account and a netbanking account, starting ETFs is a 2 minute job once you have decided on the ETF and amount. I suggest investing via SIP / SEP You just need to log into your trading account, go to the section on SIP / SEP, enter the ETF, the quantity and frequency and press enter. Every month, the set amount of units will be purchased and your netbanking account debited with the money.