this article by Suraj of moneycontrol.com first appeared on ibnlive.com – i have reproduced it here as it contains my quote and reasonably explains what is an etf. So here it is as a part of my tutorial…

Hovering at around 9,000 levels, the Sensex has shed more than 50 per cent of its value, since the beginning of this calendar year!

By now, we all know the oft-repeated ‘buy low sell high ’ mantra. So, with equity prices beaten down badly, it does not take rocket science to decipher that now is perhaps indeed the right opportunity to buy good quality stocks at low prices.

However, as a layperson, how do you define a good stock? How would you know which stock will give you good returns once the markets take a ‘U’ turn?

Instead of laying your bets on a single stock (and not being sure if it will do well), wouldn’t it be better to simply invest in the index? This way, once the market shoots up, so does your investment and therefore, your returns!

Is it possible to invest in the index? Yes, one way to do this is through an Exchange Traded Fund, or ETF, as it is popularly known.

What are ETFs?

ETFs, like index funds, are mutual fund schemes that invest in stocks in exactly the same proportion as that of a given benchmark index. For instance, the Nifty BeES ETF from Benchmark Mutual Fund invests in the same stocks that the S&P CNX Nifty Index is comprised of.

As the name suggests, they are traded on the stock exchange. This means, you can buy and sell ETF units anytime during market hours. This is where they differ from index funds which also invest in index stocks but cannot be traded.

To invest in ETFs, you need a trading as well as a demat account.

Why choose ETFs?

ETFs are a good bet for more reasons than one.

1. Market linked returns

Statistics show that in the long term (all blocks of 5 years for the past 25 years in India), equity returns have surpassed that of every other asset class. Since ETFs invest in securities that form a part of a particular index, their returns are more or less in line with index returns. So, if you have invested in a Sensex based ETF, once the benchmark zooms up, you can be sure that your Sensex based ETF will go up too!

With diversified equity funds, your returns may or may not exceed market returns, that is, your equity fund may not outperform the index.

2. Low costs

ETFs are generally passively managed. This means that the ETF merely invests in index based stocks and does not deviate into investing in other stocks. Since the ETF does not buy or sell its stocks often, it has lower expenses than that of an actively managed fund. For example, the Nifty BeES has a cost structure of around 0.50 per cent, much lower than what conventional mutual funds levy (around 2.5 per cent).

3. Low tracking error

Tracking error is the difference between ETF returns as against that given by the index it tracks. The lower the tracking error, the better is the performance of the fund. Index mutual funds as well as ETFs aim to achieve a tracking error close to zero. ETFs have been seen to have maintained a low tracking error.

4. Real time buying and selling

Other mutual funds can be bought and sold only at the day end’s net asset value (NAV). However, you can buy and sell ETFs just like stocks, that is, during trading hours, which also makes them more liquid.

ETFs offer the best of both worlds – they are mutual funds but are traded like stocks.

PV Subramanyam, financial domain trainer strongly recommends index based ETFs in an investment portfolio. When the markets recover, ETFs that mimic the index will be the first to come up and give attractive returns over the long term.