How ETFs work and their types

Dec 23, 2020

Exchange Traded Funds, or ETFs, and index funds are passive instruments.

An index fund is a type of mutual fund whose holdings match or track a particular market index. Same with an ETF, which is designed to track a particular index.

When it comes to an index fund, the Net Asset Value, or NAV, is declared at the end of the day and investors can buy and sell units at this price.

The difference is that an ETF is listed on a stock exchange, just like shares. And are traded on a real-time basis. A major plus point of ETF is that you can take advantage of real-time price which could help you to book profit instantaneously in an intra-day high NAV. A real-time NAV is particularly beneficial during times of high market volatility, subject to the availability of liquidity. This advantage is missing in index funds where you can trade only at NAV declared at end of day.

Index funds come with regular and direct plans. You can buy an index fund from your distributor or adviser, and you do not need a demat account. But you do need the latter when buying an ETF. Since it is listed on the stock exchange, a demat account is mandatory.

Investors should factor in that they incur trading costs while transacting in ETFs.

ETFs are created by large money managers who bundle the underlying instruments of the fund together. It is offered for sale to the public and can be purchased through a broker. The ETFs track indexes for stocks (domestic and international), bonds, commodities, gold and currencies. One can buy ETF on margin, short sell, or hold for the long term.

A major advantage of both index funds and ETFs is their simplicity, low cost and diversification. Do note that index funds can charge a slightly higher expense ratio as compared to ETFs.

Types of funds

Investors have different options under ETFs/index funds, depending on where the product invests and the strategy. Here are some broad categories:

Sector based

Some fund houses offer sector-based ETFs funds that track sectoral indices such as banking, PSU Bank, private bank, infrastructure and information technology indexes. The risk involved in such sectoral ETFs funds is higher than other diversified passive funds because the entire portfolio exposure is concentrated in that single sector. One sector/theme may not perform every year as winners often rotate depending on the economic cycle, as is evident from the historical performance of such funds. So one would do well to steer clear of such ETFs, unless one is seeking a tactical exposure based on a strong view on the sector. The risk of investing in a sector ETF is aggravated vis-à-vis investing in an actively managed sectoral fund since ETFs are designed to hold the underlying stocks as per the weightage in the index at all times. 

Market cap weighted funds

Such ETFs/index funds invest in stocks in the same proportion as their weightage in the benchmark index. For instance, let’s consider an index fund tracking the Nifty 50 index. HDFC Bank has the highest weightage in the Nifty 50 index at 11.21%. The market cap weighted index fund tracking Nifty 50 will try to hold approximately the same weightage (11%) of its net assets in HDFC Bank. One disadvantage of this strategy is that investors could be exposed to stocks that are overvalued, due to which a few stocks becomes a large portion of the index. Unlike active funds where fund managers decide the weightage of stocks based on their view, index funds and ETFs follow a rule-based investment methodology. This eliminates human bias.

Equal weighted funds

Equal weighted index funds try to hold a fixed percentage of the fund’s assets, say 2% each in the underlying index at all times. So an equal-weighted index fund will hold 2% in the above-cited example even if HDFC Bank’s weightage in the underlying index is more than 11%. This ensures that investors have an equal amount of diversification to all 50 stocks in the index. In the same vein, an equal-weighted index fund will hold 2% in Tech Mahindra, whose weightage in the Nifty 50 is 0.97%. 

Debt ETFs 

As the name suggests, debt ETFs give exposure to investors to the fixed income market. In India, investors have limited options that include Liquid ETFs, PSU Debt ETFs, government securities or gilt ETFs. Gilt ETFs are a safer option for investors as they do not carry any credit risk. However, the returns from gilt securities are susceptible to interest rate changes.

The government of India has started utilising debt ETFs as a way to attract a larger number of investors. The Debt ETF market is still in its nascency with limited issuers and lack of liquidity. 

Gold ETFs 

Gold ETFs aim to mimic the domestic spot price of gold as closely as possible. Asset managers create units of the scheme which are listed on stock exchanges. These units are backed by physical gold and are held in custodian accounts. Each unit of the scheme is typically equal to 1 gram of gold, depending on the ETF. Gold ETFs are a convenient and low- cost way of taking exposure to gold prices. 

Smart beta

Fund houses offer smart beta ETFs which follow a rule-based investing approach. Such funds apply certain factors like dividend yield, momentum, quality, low volatility, and so on while selecting stocks. Such ETFs can be thought of as a hybrid between passive and active investing, along with the benefit of low-cost investing. Investors can choose a fund that offers a portfolio that filters securities based on a combination of factors, rather than the conventional market-cap weighted index fund/ETF.

To sum up, choose a fund that best suits your goals and investment horizon by consulting your financial adviser.

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ninan joseph
Dec 23 2020 03:02 PM
It is advisable to invest in ETF wherein the underlying security or instrument is as diverse as possible. Example - Nifty or Sensex ETF. This is as diverse as we can get.
Factors to be considered
1. The AUM should be checked before investing. Nifty 50 ETF is offered by many AMC such as SBI, Kotak etc. All do the same thing, invest in Nifty 50 stocks, but check out who has the highest AUM and lowest of commission. In my view SBI ETF which manage 73,000 cr of AUM has a commission of 0.07%.
2. For Investors in stock market, ETF is like a FD. There will be minor volatility but in the end if you believe that Index will go to 15,000 or 20,000 in the next few years then your ETF will also increase. ETF just mirrors the index.
3. The top 50 companies are listed in the index. As and when a company is removed from the index the AMC managing the ETF will also removes that company. In this way, you are protected that your money is invested in the best of companies. Example - Vedanta was removed as it was getting delisted. I think much more than delisting, it was the crooked management, hence they dropped it. This reshuffle happens and this will ensure that your money is protected. Example - FT invested in Vodophone in their liquid fund or so when the company was in losses for the last so many years. These kind of quasi fraud will be reduced in ETF as only the best remains in the index.
4. The commission they charge is the lowest and think of removing all your index funds and move to ETF. Of course you need a brokerage account and they will charge you. This is a factor you should consider.
5. Do not go for fancy ETF such as Alpha ETF or sector fund ETF even Gold ETF. Invest only in those ETF which is followed by many. Hence Nifty 50 or Sensex ETf is the best.

There is another ETF called Nifty next 50 ETF. This one has 50 companies which fall after nifty and hence you could consider this ETF as well.
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