Types of exchange traded funds
Exchange traded funds (ETFs) are securities which represent pooled funds that are invested in shares of an underlying class of asset or specific regions or commodities, etc. The reason they differ from mutual funds is that they can be traded on stock exchanges during the day, unlike the units of mutual funds, which acquire their net asset values at the end of the trading session. The concept is relatively new. The object is to offer investors some liquidity on investments, without depriving them of risk mitigating diversification benefits that mutual funds offer. In addition, ETFs also have services of professional fund managers who manage the portfolios, like in mutual funds.
Investors are also able to invest even small surpluses they can spare into ETFs on investments that require large amounts, like real estate, gold, infrastructure, etc.
Returns on these investments are also higher than those in mutual funds, because of lower commission and administration charges, apart from tax planning advantages.
ETFs also enable investors to speculate in commodities, foreign exchange, bullion, etc., through stock exchanges. These assets are, otherwise, not tradable on stock exchanges.
What are close ended and open-ended exchange traded funds?
Like mutual funds, ETFs can also be close ended or open-ended funds. Close ended implies that once the fund is launched, the corpus cannot be increased. Any gains, if at all, will be associated with the units or securities that were issued at that time. Growth funds fall under this category. Open-ended ETFs, on the other hand have flexibility regarding their corpus. In addition to the initial corpus, these funds can continue to take funds, which are again reinvested in the underlying assets as defined at the outset. Generally, ETFs fall under this category.
Income distribution procedures in ETFs are also like mutual funds. There is a dividend distribution, and a managed distribution. When the funds receive dividends and interests on their investments, they set off administration and charges against them and distribute the surplus to the unit or shareholders of ETF in monthly, quarterly, half-yearly, or yearly periods. Managed distribution relates to capital gains accruing from sale of any of the underlying asset or part thereof. This requires approval from Securities and Exchanges Board.
Types of underlying class of assets in exchange traded funds
ETFs can be
Based on market capitalization:
a. Small cap i.e., investments in the fund will be redeployed into companies that have smaller capitalization in the securities market. Investing in individual shares of small cap companies is risky because they offer high-risk high return type of investment opportunity. However, when such risk is diversified into a number of small cap companies with the help of pooled funds, the returns are reasonable, and risk is considerably reduced.
b. Mid cap these are ETFs focused on companies that have market capitalization that falls in the range between small and large caps. The risks and returns are lower when compared to small caps.
c. Large cap these ETFs focus on companies that have high market capitalization. The prices of securities are higher, and proportionate returns in form of dividends are lower. However, these investments show considerable steadiness in returns. This quality of such investments fetches them higher value in form of capital gains.
Based on emerging and developed markets:
a. Emerging markets the ETFs that are formed to invest in emerging markets look for investing in countries whose economies are just beginning to rise on horizon, and have bright future prospects. Risks and returns in such funds are also comparatively higher.
b. Developed markets ETFs seeking to invest funds in other developed markets are generally the ones that are seeking diversification for reducing their current exposure to one country.
Industry based ETFs:
Some ETFs specifically track the trends in prices of stocks of a particular industry, by investing in shares of that industry. Industries selected for such tracking include real estate, infrastructure, energy, information technology, biotechnology, etc.
Commodities based ETFs:
a. Gold and Silver exchange traded funds help even small investors to invest in such assets, which were hitherto only the domain of the rich.
b. Commodities like wheat, sugar, edible oils, etc., witness price fluctuations on day-to-day basis. Some ETFs, therefore, track the prices of any one or more of these commodities.
c. Oil based ETFs are generally considered a separate category. This is because oil prices and exploration has such a big impact on exports, imports, trade deficits, and economies in general. These ETFs are designed to track trends in oil, gas and petroleum prices.
d. Currency based ETFs are also launched. These track one or more currencies.
Index based ETFs:
Companies like Standard and Poors?, and Dow Jones, issue indexes comprised of stocks related to a particular industry, or shares representing the stock markets. Such indexes are merely lists of stocks and their price movements are indicative of trends in the industry or stock market these lists relate to. The returns generated by the stocks in these indexes are taken as sort of benchmark.
ETFs tracking such indexes also hold similar portfolios. An individual investor may or may not be able to invest in all the stocks of an index. However, pooling funds enables the investor to reap higher returns on even a smaller investment. In addition to the above varieties, some ETFs are designed for specific term, like 1, 2 or 5 years, etc. After the expiry of the term, the assets of the fund are liquidated, profits are distributed, and the fund is closed. Such ETFs have some bonds or fixed maturity debentures etc., as their underlying securities.
Regulatory environment:
Because ETFs are traded on stock exchanges, it is inevitable that they be governed by the Securities and Exchanges regulations of the country in which the fund is launched. In addition to SEC, ETFs are also governed by some mutual fund regulations, as they are pooled funds. Investment companies may offer some ETFs; therefore companies? act also has its say in such cases.
Risks:
Like all mutual fund investments, ETFs are also subject to risks. The risks involved are:
a. Market pricing
b. Credit risk
c. Tracking error
d. Interest rate risk
The above risks are in the hands of the portfolio manager.
Investor can also err by selling a unit before it attains its full price or buying a unit at a much higher price in the stock exchange.
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