What is an Exchange Traded Fund (ETF): A Complete Guide

In the previous blog, we took a detailed look at the index funds. In this blog, we will take a deep dive into the Exchange Traded Funds (ETFs).

What are Exchange-Traded Funds (ETFs)?

Exchange-Traded Funds (ETFs) are just like mutual funds, where the money is pooled from various investors and is used to invest in a basket of securities. So, how are they different from mutual funds or index funds?

Unlike mutual funds, ETFs can be traded on the exchange during market hours. Meaning, they can be bought and sold just like stocks. We saw that mutual funds try to outperform their respective benchmark. But ETFs on the other hand try to generate returns similar to their respective benchmark. In this regard, they are similar to index funds.

For example, Nippon India Nifty ETF Nifty BeEs tries to generate returns similar to the returns of the NIFTY 50 Index.

Now, while buying mutual funds we used to check the NAV of the mutual fund that was published by the fund house at the end of the day. On the other hand, ETFs trade throughout the day on the exchanges, and their price moves continuously during market hours depending on supply and demand as well as other factors. In this regard, ETFs are similar to stocks. One of the major advantages of ETFs is higher liquidity (take this with a grain of salt though). You can buy and sell ETFs immediately on the exchange. 

Just like mutual funds, ETFs also have Net Asset Value (NAV) which is published at the end of the day. NAV reflects the true value of underlying securities. But ETFs are traded throughout the day and you won’t be able to buy and sell ETFs at NAV.

So, how do you know if the price of an ETF is fair? Here, intraday Net Asset Value (iNAV) can help us. 

What is Intraday Net Asset Value (iNAV)?

iNAV provides an intraday indicative value of an ETF based on the market values of its underlying holdings. Think of it as real-time NAV.

iNAV serves as a great reference point for investors looking to transact in ETFs. If the market price of an ETF is significantly above iNAV, investors should generally avoid buying that ETF.

Similarly, If the market price of an ETF is significantly below iNAV, investors should avoid selling that ETF.

We have written an entire ETF masterclass in which we have extensively discussed all the concepts related to ETFs. You can find the link to the entire masterclass here.

FAQs

Is ETF a better option compared to Index Fund?

ETFs and index funds are both very similar in terms of investment philosophy. If you are a long-term investor, then both options will not make much difference. But if you want higher liquidity, then ETFs are a better choice, as they are tradable on the exchange.

Are tracking difference and tracking error the same?

No, even though they sound similar, they have very different meanings. The tracking difference is the absolute difference between the fund and index performance. And tracking error is the standard deviation between these two variables. Tracking difference can be negative, but tracking error is always positive.