InvestorQ : What are Exchange Traded Funds (ETFs) and how do they differ from Index Funds. How should I as an investor make a choice?
Rutuja Nigam made post

What are Exchange Traded Funds (ETFs) and how do they differ from Index Funds. How should I as an investor make a choice?

Answer
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Arti Chavan answered.
1 year ago


The big difference between an index fund and an ETF if that you have a much wider choice in case of an ETF. You can have ETFs that are linked to gold, to equity indices, to debt market indices and also to global benchmarks. Many mutual funds offer ETFs that are linked to global assets and global indices. But can you generate excess returns (alpha) from ETFs. Here are five ways to generate alpha using ETFs…

· The first approach is called a smart-beta approach. Here the ETF is benchmarked to a modified index where the tweaks are done to take a small risk and make a bigger bet on a particular theme or story. This risk should be manageable.

· ETFs generate alpha through a process called cash drag. When you operate a mutual fund, you need to maintain certain minimum cash in your portfolio. Since ETFs do not entail redemption pressure and can be sold and bought in the secondary market, the fund needs to maintain less in the form of liquidity. That enhances effective returns on an ETF.

· Thirdly, ETFs encourage large HNI investors and institutions to engage in arbitrage when the NAV of the Fund and the ETF price diverge. This ensures that the two are in sync to the extent possible. This is a big advantage over closed ended funds, which quote at a huge discount to their NAVs.

· ETFs can be used for multiple levels of diversification. Assume that you are holding an ETF on the Nifty and the index is at risk due to macro risks. It is possible to diversify that risk by buying an ETF on gold or an ETF on a global index that is negative correlated with India.

Over the last few years, passive investing has been picking up globally. The AUMs of passive funds like ETFs and index funds are growing rapidly compared to active funds and hedge funds. In India, however, there is still substantial scope for alpha generation through stock selection. However investors need to actively look at indexing as an option.