What are ETFs?
ETFs (Exchange Traded Funds) is an investment fund which is traded on stock exchange. ETF is a lot of shares that are listed and traded on stock exchange. The Basic difference of ETFs and traditional mutual funds is its availability for trading on the stock exchange.
How the price is calculated?
ETFs also have a net asset value which is popularly known as price. NAV is calculated as per the market value of the share / bonds contained in the ETFs. This also takes care of cash on hand and unpaid dividend. Thus payment of dividend has impact on the ETF's NAV. The trading price of ETF can be same as ETF can be traded on premium or discount based on demand and supply of ETFs and owing to various market factors and arbitrage.
The NAV of the ETF doesn't always represent weighted average index of the investment in the Fund. The difference is known is an ETF tracking error.
Reasons for ETF tracking error
The primary reasons for an ETF tracking error are dividend declared, expenses by fund house etc. Because of inevitable reasons, ETF tracking errors are unavoidable but as an investor, we like to see the lowest ETF tracking error for fund.
Benefits of ETFs
1. Can be easily traded on the stock exchange during trading hours like shares. Price is available online or through any stock broker.
2. Transparency is better because it publishes the list of investment daily.
3. Liquidity is also as good as it can be sold on the markets during trading hours.
4. Users can benefit from diversification within an asset class.
5. Investors can avail of tax benefits for dividends received.
6. It doesn’t not require active participation of investors as buying and selling of shares are managed by fund manager.
Limitations of ETFs
1. It provides very limited geographic diversification as funds don’t represent stocks listed on other world market.
2. Higher tracking errors directly affect investor’s profit & loss. Investors should go for lower tracking errors.
Regards
Team TheEquityMarkets
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