17 June 2013

Understanding ETF's - Part 2

In our previous article we had seen the basics of the concept of ETFs. Let's throw some more light on this topic. If you are reading this article directly, I suggest you read our part 1 completely.

As an investment tool, ETFs give you the power to exploit the growth prospects of a particular country, sector ( IT, Pharma, Banking, etc ) or an index. In India, we do not have ETFs totally developed for all sectors or other developing countries, we do have some for USA, HongKong, etc. Even when it comes to sectors, we do not have ETFs for all the sectors excepting banks. The best ETFs to invest in here are for NIFTY and GOLD. These have good trading volumes, the expense ratio is approximately 1% and thus provide good investment opportunities.

India Shining?

India, as we know is a growth story. Yes, the past few years have been tough and we have faced many hurdles in coming up with new economic reforms, but if long term prospects are seen, India has a very big growth story going forward and our stock markets have a big bull market lying ahead of us. Picking up a good stock for investment requires a very sharp understanding of the financials, understanding of the industry and many other dynamics. Buying an index ETF or a sectorial ETF diversifies your risk as you are BUYING the market. For easy understanding, take the NIFTYBEES. This NIFTY tracking ETF trades as 1/10th of the index. We all know that in the future NIFTY will rise, like it has doubled in from the 2009 period but in the same time, big stocks like Tata Steel, BHEL, Suzlon, Educomp have destroyed investor wealth. This leaves us with the risk of missing the market growth and losing wealth in stocks that did not participate in the rally if individual stocks are bought. If you had bought the ETF, you could have ridden the rally. Over the past years, markets have given an annual compounded returns of 15%-16%! More than fixed deposits who give around 6.5% after tax returns.
Have you always felt that you missed out on the GOLD rally? And that Gold just kept getting costlier for you? Well, ETF would have pretty much solved that problem too! The Gold ETF. There are ETF's that track the banking index, midcap and small cap index but have a very low trading volume which makes them lose shine. Also, these have not given good returns in the past few years.
Let's discuss the 2 popular ETF's in India.


Regularly investing index ETF's give you the exposure of the entire market and keeps your profits running as and when the market goes up. Suppose you decide to monthly invest a fixed amount in an index ETF, you are able to buy different quantities of the fund every month. When the market is low, you get to buy more units and when it starts moving up, you get to buy lesser units. And in our growing economy, this seems the best investment for the long term. The only cost is the brokerage for buying it and the expense ratio you pay annually. This expense ratio is usually 0.75%-1%, also you get the benefit of dividend which the index companies pay. As the index comprises companies of every sector of the economy, you get a diversified exposure to risk.

Advantages of INDEX ETF:
  • Spreads your risk over diverse sectors of the economy.
  • Let's you invest small amounts now to make money from the future bull rally.
  • Gives you dividends from the index companies.
  • The market men are very intelligent and always remove under-performing stocks from the index and add upward running stocks to it. It does sound safe.
Disadvantages of INDEX ETF:
  • Annual cost (Expense Ratio) is close to 0.75%-1% compared to lowly 0.2% in developed markets.
  • If the market falls or remains stagnant over a period of time, investment fails and could lead to negative returns for a few years.
  • If the ETF is shut down, you will GET BACK YOUR MONEY but will have to find another ETF to invest those funds in.
  • Comparative returns might be low compared to midcap stocks which multiply over years. You lose out on this as an oppurtunity cost of investing in the ETF.

Gold does GLITTER.

It trades at the price of 1 gram of gold (Most cases). Every unit of this ETF is backed by  99.5% pure 1 gram gold. If you want to make money out of rising gold and can't take the risk of the commodity markets then invest in the gold etf. If you are saving money to BUY gold for your children's wedding then don't let the money lie in jewellery or bank lockers. Start buying gold etf from the beginning. In that way, you add gold to your treasury from the lower prices and years from now, you can have a lot of gold! Just the way you would want it to be. You can redeem the units for gold for every 1 KG of gold and a multiple thereof (2KG, 3KG, 4KG and so on). But a better way would be to sell the investment in Gold ETF and buy physical gold with that amount.

Advantages of GOLD ETF:

  • No storage cost, no risk of loss due to theft, natural disaster or other matters out of our hands.
  • A very small amount required to make monthly investment. As low as the price of 1 gram of gold.
  • It can be bought and sold at the cost of an equity share during the market hours and has good liquidity.
  • As Indians would never want to sell gold they hold unless they are bankrupt, ETF removes tis psychological barrier if you wanted to make money from gold.
Disadvantages of GOLD ETF:

  • If gold price falls over the next few years, you will lose money in the investments made early on.
  • Annual cost (Expense ratio) is 1% approximately in the Indian markets compared to lowly 0.2% in foreign markets.
  • If the fund closes down it's gold exposure, you will GET BACK your money but will have to re-invest in another GOLD ETF to keep the investment plan intact. 

If you are not an active investor, but want to make use of the booming markets and commodities (Gold), ETF is the way for you to go and ride the bull run and make money from it. Buy it for long term, hold and and add to it periodically in small amounts and you will see how these are great investments apart from the traditional fixed deposits. The best part, you don't have to understand balance sheets, dynamics and all of those stuff. You are BUYING the market! And India WILL create new highs in the coming decades. They might sound too exotic now, but we will see with time how they gain the "thumbs up" of the Indian investor.

Disclaimer: Investment in any market related instruments are subject to price changes. The opinions expressed here are those of the author and we don't bear any responsibility for the profits and losses incurred on any investment based on these opinions.

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