What is an ETF (exchange-traded fund)?
An index is a list that tracks a group of shares, such as the top 50 or top 500 companies. An index fund buys the same shares in the same proportions.
An ETF is an index-style fund whose units are listed on the stock exchange. You buy and sell them through a broker and a demat (electronic) account, at the market price, any time the exchange is open.
Kinds: equity index ETFs, gold ETFs (track gold price), bond ETFs, sector ETFs and international ETFs.
Features and uses of ETFs
- Low cost: passive management, so the expense ratio is usually very low.
- Traded all day: price changes during the day; you can buy at a limit price.
- Transparent: holdings are the index, known to all.
- Diversified: one unit gives a slice of many companies.
- Tracking error: the small gap between the ETF's return and the index return (due to fees, cash and timing). Lower is better.
- Needs a demat account and brokerage; the price may be a little above or below the ETF's NAV.
Uses: long-term low-cost investing in the whole market, owning gold without storing it, and quick exposure to a sector.
ETF vs mutual fund: a normal open-ended fund is bought from the fund house once a day at NAV; an ETF is bought from other investors on the exchange at the live price.
Debt funds: lending, not owning
A bond is a loan with a fixed face value, a fixed coupon (interest, e.g. 7% a year) and a maturity date. A debt fund holds many bonds and money-market papers.
Kinds: overnight and liquid funds (very short), short-duration funds, corporate bond funds, gilt funds (government bonds only, almost no default risk), and credit-risk funds (lower-rated bonds, higher interest, more risk).
Two risks:
- Interest-rate risk: when market rates rise, existing bonds paying less become less attractive, so their prices fall. Approximate rule: % change in price ≈ − duration × change in rate. Longer bonds have higher duration.
- Credit (default) risk: the borrower may not pay. Credit-rating agencies give grades like AAA (safest) to D (default).
Liquid funds: parking spare money
A liquid fund invests only in papers that mature within about 91 days: treasury bills, commercial paper, certificates of deposit. Because the loans are so short, a rate change hardly moves the price.
- Very low risk and steady, small returns (usually a bit above a savings account).
- Money can usually be withdrawn the next working day.
- Uses: emergency fund, money waiting to be invested, a business's spare cash for a few weeks.
Key formulas and definitions
- ETF value = units × market price
- Tracking error ≈ index return − ETF return
- Bond coupon (₹) = face value × coupon rate
- Current yield = yearly coupon ÷ market price × 100
- % change in bond price ≈ − duration × change in interest rate
- Liquid fund: maturity ≤ about 91 days
Worked examples
1. You buy 20 units of an index ETF at ₹250 each. Later the price is ₹270. Find the cost, the value now and the gain %.
Cost = 20 × 250 = ₹5,000. Value = 20 × 270 = ₹5,400. Gain = 400 ÷ 5,000 × 100 = 8%.
2. An index rises 12% in a year and the ETF that tracks it rises 11.8%. What is the tracking difference?
12 − 11.8 = 0.2 percentage points, mainly due to fees and small cash holdings.
3. A bond has face value ₹1,000 and a 7% coupon. How much interest does it pay a year? If its market price is ₹950, find the current yield.
Coupon = 1,000 × 0.07 = ₹70. Current yield = 70 ÷ 950 × 100 ≈ 7.37%.
4. A debt fund has a duration of 4 years. Interest rates rise by 1%. Roughly how much does its value change?
% change ≈ −4 × 1 = −4%. A ₹10,000 holding falls to about ₹9,600.
5. Same rise of 1% for a liquid fund with duration 0.1 year. Change?
≈ −0.1 × 1 = −0.1%. ₹10,000 falls only to about ₹9,990, which is why liquid funds are stable.
6. Rates fall by 0.5%. Fund A has duration 6, fund B duration 1. Which gains more and by how much?
A: +6 × 0.5 = +3%. B: +1 × 0.5 = +0.5%. Long-duration fund A gains more (and would lose more if rates rose).
Common mistakes
- Thinking debt funds can never lose value. Rising rates or a default can lower NAV.
- Believing bond prices rise when interest rates rise. It is the opposite.
- Thinking an ETF is bought from the fund house like a normal fund. It is bought on the stock exchange.
- Using a long-duration debt fund for money needed next week. Use a liquid fund instead.