What Is an ETF? A Complete Guide to Exchange Traded Funds in India

What is an ETF? An exchange-traded fund (ETF) is an investment fund, whose units are traded on a stock exchange during market hours, similar to shares of a company. Rather than the investor buying the shares of one company, with the ETF, they can buy a basket of shares including those of the companies that form an index, a portfolio of bonds or gold or the international stock market.

The meaning of ETF for Indian investors becomes clear when the ETF is viewed as a confluence of two familiar investment concepts: a mutual fund, which holds a portfolio of securities and a stock that can be bought or sold on an exchange during the trading session. This provides the diversification and the market-linked exposure, but ETFs are not a risk-free or guaranteed return product.

This article explains how Exchange Traded Funds work in India, how the ETF price and Net Asset Value (NAV) relate, the different types of ETFs, their costs and benefits, their risks and the factors that investors should look out for before investing.

What Is an ETF?

An Exchange Traded Fund is a pooled investment vehicle that generally seeks to track the performance of an underlying index, asset, market or basket of securities. The underlying portfolio determines what the ETF is designed to represent.

For example, an equity ETF may track a broad market index, such as the Nifty 50. A sector ETF may track the performance of a specific sector or industry. Other ETFs may provide exposure to gold, bonds, international indices and more.

The main difference between an ETF and a conventional open ended scheme is that ETFs are traded on the stock exchange. Therefore, their shares can be bought and sold throughout the trading day, just like shares of any other listed company. The price of an ETF is determined by the forces of demand and supply in the market during trading hours. In contrast, with an open ended scheme, investors can only buy or sell the units of the scheme directly from/to the fund manager at the end of the day at a price that reflects the scheme’s Net Asset Value (NAV).

Therefore, if you would like to know more about the ETF investments that are available, you can learn more here.

How Do ETFs Work?

The easiest way to think about how ETFs work is at the level of the fund itself, its underlying portfolio, the NAV and the exchange price.

1. Underlying portfolio: The ETF is designed to hold securities or assets which reflect its investment objective. An index ETF may hold the securities in proportions designed to replicate its benchmark.

2. Creation and redemption: Units of the ETF can be created or redeemed using the fund's designated mechanism and typically in large blocks or 'creation units' by authori sed participants or other eligible market participants.

3. Exchange listing: Individual investors can buy and sell ETF units on a stock exchange through a demat and trading account.

4. Market price: Individual investors can trade ETF units on a stock exchange during normal market hours. The ETF has a traded price which varies according to supply and demand.

5. NAV: The fund calculates a NAV based on the value of its underlying assets and liabilities. The exchange price can trade above or below the NAV.

The arbitrage activity of market participants combined with the fund's creation and redemption mechanism is intended to keep an ETF's traded price reasonably close to the value of its underlying portfolio. However, investors should not assume that the exchange price and the NAV are always the same.

ETF Price vs NAV: What Is the Difference?

NAV stands for Net Asset Value. It represents the per – unit value of the ETF’s entire portfolio net of any liabilities.

On the other hand, the market price of an Exchange Traded Fund is determined by the forces of demand and supply in the stock market. Therefore, the market value of an ETF may deviate from its NAV because of the continuous fluctuations throughout the trading day.

For this reason, investors should not rely on the prices at which an ETF is bought and sold in the market as a sole criterion for investment. Instead, they should consider factors such as market liquidity, bid-ask spread, tracking difference, expense ratio and the nature of the underlying portfolio.

What Are The Different Types Of ETFs In India?

ETFs can be categorised based upon the asset, index or market that they track and represent. Some of the common types that investors might come across in India include:

Equity ETFs

Equity ETFs are funds that hold a basket of shares and generally track an equity index. Broad-market ETFs offer diversification by encompassing numerous entities in a single security, with diversification depending on the index that the ETF is tracking.

Sector ETFs

Sector ETFs focus on a particular group or sector, such as the banking, information technology or any other specified segment. Sector ETFs generally track a narrower market segment and thus have the potential to offer more concentration risk than a broad market ETF.

Gold ETFs

Gold ETFs represent the mechanism by which exposure to gold-related pricing can be attained via the vehicle of an exchange-traded fund mechanism. Gold ETFs enable investors to gain market exposure without having to hold physical gold, although with their own costs, structures and tracking risks.

Bond and Debt ETFs

Bond ETFs offer exposure to a portfolio of fixed-income securities. The risk profile of a bond ETF depends on the underlying bonds, the interest rates, credit risk, maturity profile and the structuring of the particular ETF.

International ETFs

International ETFs can offer exposure to foreign markets or indices. Alongside the risk associated with the underlying securities, there is also potential exposure to currency and international market risks for international ETFs.

Commodity and Other ETFs

Some ETFs are created around commodities or other market exposure. Investors should research what it is an ETF they are considering is actually tracking or representing as certain funds can be tracking obscure markets or products.

What Are the Main Benefits of ETFs?

ETFs have become popular as an investment instrument due to their ability to offer diversification, while retaining flexibility of trading on the exchange. Nonetheless, whether they are a suitable choice depends on the particular needs and goals of each investor, as well as on the risks associated with any particular security.

1. Diversification Through One Investment

An ETF which tracks a diversified index allows the investor to participate in the performance of a variety of securities, which reduces the risk of being overly dependent on any one particular asset. Nonetheless, diversification cuts down, but does not eliminate the risk of loss.

2. Exchange-Based Trading

Unlike the traditional open-ended mutual fund transactions, ETF units are traded on the stock exchange during market hours, allowing the investors to buy or sell them at the market price, which depends on the supply-demand forces, liquidity and other exchange-related trading conditions.

3. Transparency of the Underlying Portfolio

The investment objective and the relevant benchmark of an index-based ETF are generally well-defined, thus, allowing the investor to understand the market segment the fund tracks; however, there is always a need to research the ETF-specific documents.

4. Potentially Lower Fund-Level Costs

Compared to actively managed funds, passive ETFs usually have lower expense ratios; however, they should be evaluated together with other costs, such as brokerage, bid-ask spreads, tax implications and others.

5. Flexibility

As ETF units are traded on the stock exchange, investors can buy or sell them during market hours, thus, having more flexibility than other investment vehicles which typically settle trades at the end of the trading day.

What Are the Risks of ETFs?

Understanding ETF risks is critical to understanding their benefits. An ETF should not be classified as a risk-free or guaranteed investment based solely on the diversification benefits that it provides

Market Risk

If the underlying index or asset is falling in value, the ETF can also fall. A broad-market ETF is subject to overall market movements, while sector or thematic ETFs can experience larger swings due to their concentration.

Liquidity Risk

Not all ETFs are as liquid as the underlying asset. Thinly traded ETFs can have a large bid-ask spread and may be difficult to transact in at the desired price. The SEBI ETF risk disclosures also include the possibility of limited secondary-market liquidity and trading halts in certain circumstances.

NAV and Market-Price Difference

ETF units can sell for more or less than NAV. This difference can be more significant in thinly traded or inaccessible markets or in different time-zones.

Tracking Error and Tracking Difference

An ETF that tracks an index can deliver a different return than the underlying index due to costs, cash holdings, portfolio adjustments, taxation, corporate actions and the mechanics of replication.

Concentration Risk

An ETF may appear to be diversified, but it may be focused on one sector, theme, country or asset class that can negatively impact returns. Investors should examine beyond the number of holdings and see the concentration in the portfolio.

Currency and International Risks

International ETFs can be affected by exchange rate movements and events in the underlying country or region. Political, economic, regulatory and market conditions in the underlying country or region can also impact returns.

ETF Costs: What Should Investors Check?

When comparing ETFs, investors should look beyond the headline expense ratio. The actual cost of owning an ETF can include several components.

For a long-term investor, comparing expense ratios and historical tracking performance can be useful. For an investor who trades more frequently, liquidity and bid-ask spreads can become particularly important.

How to Buy ETFs in India

ETFs are similar to shares in that buying an ETF is similar to buying listed shares. Typically an investor will need to open a demat and trading account with a brokerage that has access to the relevant exchange.

1. Open a demat and trading account: The account provides the necessary infrastructure to hold and trade listed instruments such as ETFs.

2. Select the ETF: evaluate the ETF's benchmark, asset class, portfolio, expense ratio, liquidity and tracking history

3. Check the live market price: compare the traded price to the available NAV or indicative value information where relevant.

4. Review the bid-ask spread: a narrow spread can be important to consider in relation to execution costs, especially for less liquid ETFs.

5. Place the order: Investors can place an appropriate exchange order based on their own strategy and risk considerations.

6. Monitor the investment: Periodically review the ETF's objective, tracking performance, costs and portfolio exposure.

Investors who need access to listed securities can learn more about an equity trading account before deciding how they want to participate in the market.

ETF vs Mutual Fund: What Is the Basic Difference?

ETFs and mutual funds both pool investors' money to create portfolios, but their trading structures are different. An ETF is listed and traded on an exchange, while a traditional open-ended mutual fund is generally bought or redeemed with the fund at the applicable NAV.

Neither structure is automatically better for every investor. The right comparison depends on the investment objective, costs, convenience, liquidity requirements, tax considerations and the specific product.

How Should Beginners Evaluate an ETF?

A beginner should avoid selecting an ETF only because its recent return appears attractive. A more useful evaluation process is to start with the underlying exposure and then examine how efficiently the ETF delivers that exposure.

• Understand the benchmark: Know which index, asset or market the ETF follows.

• Check the portfolio: Look at the securities, sectors, countries or asset classes represented.

• Compare expense ratios: Costs can affect long-term outcomes.

• Review tracking performance: Check how closely the ETF has followed its benchmark over different periods.

• Assess liquidity: Look at trading volumes and bid-ask spreads rather than assuming every ETF trades equally actively.

• Check the NAV and market price: Understand whether the ETF is trading at a premium or discount to its NAV.

• Understand the risk: A diversified ETF can still fall when its underlying market or asset class declines.

• Read scheme documents: Confirm the investment objective, replication method, risk factors and applicable charges.

Are ETFs Suitable for Long-Term Investors?

ETFs can be suitable for long term investors due to their capacity to provide diversified exposure toward a certain index or asset category. However, the suitability should be determined according to the chosen ETF product and personal financial goal.

A broad market ETF is expected to offer diversified equity-based exposure, whereas a sector ETF is more concentrated and risky. A bond ETF and a gold ETF represent completely different asset classes, each with unique sets of risks and benefits. Therefore, long-term investors should focus on the risk-return characteristics of the underlying assets and consider the cost, tracking quality and role in the portfolio when determining the suitability of an ETF.

What Should Investors Remember About ETFs?

• An ETF is essentially a pooled investment product which is traded on a stock exchange.

• They can offer diversified exposure to a portfolio of securities, an index, a commodity, bonds or an international market.

• An ETF’s market price can deviate from the NAV.

• Liquidity and wide bid-ask spreads also impact the real value of the ETF.

• The expense ratio and tracking difference are also critical in comparing similar products.

• Diversification can reduce single-stock concentration risk but cannot hedge against overall market fluctuations.

• Sector, thematic, international and commodity ETFs involve different levels and types of risk.

• Investors should always read through the relevant scheme documents before investing.

Conclusion

Understanding what is an ETF is critically important to new investors who are interested in passive investment products. An ETF involves a pooled investment structure and exchange-traded mechanism, enabling individual investors to access diversified or specialized investment tools with relative ease.

However, an ETF product is not a guarantee of lower risks due to diversification or market-cap-weighted index-tracking structures. Investors should research the relevant exposure, compare costs, examine liquidity, tracking ability and remember the possibility that the price of an ETF can deviate from the underlying NAV. As a beginner’s guide, the emphasis is on learning to evaluate the relevant risk and return characteristics of an ETF, rather than chasing the product with the best recent performance.