ETFs are just what their name implies: baskets of securities that are traded, like individual stocks, on an exchange. Unlike regular open-end mutual funds, ETFs can be bought and sold throughout the trading day like any stock.

Most ETFs charge lower annual expenses than index mutual funds. However, as with stocks, one must pay a brokerage to buy and sell ETF units, which can be a significant drawback for those who trade frequently or invest regular sums of money.

They first came into existence in the USA in 1993. It took several years for them to attract public interest. But once they did, the volumes took off with a vengeance. Over the last few years more than $120 billion (as on June 2002) is invested in about 230 ETFs. About 60% of trading volumes on the American Stock Exchange are from ETFs. The most popular ETFs are QQQs (Cubes) based on the Nasdaq-100 Index, SPDRs (Spiders) based on the S&P 500 Index, iSHARES based on MSCI Indices and TRAHK (Tracks) based on the Hang Seng Index. The average daily trading volume in QQQ is around 89 million shares.

Their passive nature is a necessity: the funds rely on an arbitrage mechanism to keep the prices at which they trade roughly in line with the net asset values of their underlying portfolios. For the mechanism to work, potential arbitragers need to have full, timely knowledge of a fund's holdings.

ETFs are not futures

Even though ETFs and Futures allow investors exposure to an index, they are different in many regards. While Futures is a derivative product and trades in the F&O segment of NSE, ETFs are a cash market product and trade in the Capital Market segment of NSE. The maximum tenure available for futures is 3 months while ETFs can be held for as long as the investor wants.

Index Tracking

Index tracking has been widely acclaimed in practice and in theory as a winning strategy for long term investing. It has been the experience that globally, a majority of actively managed funds have under performed their respective benchmarks over a long period of time.

William Sharpe, a Nobel laureate in Economics, believes that all active fund managers together can never outperform the market. Consequently, all classes of investors viz. institutional and retail are increasingly moving towards investing in well-defined indices, which are professionally managed. In fact the largest mutual fund scheme today is an index fund on the S&P 500 managed by Vanguard.

Index Funds

An Index Fund is a mutual fund that tries to mirror a market index, like Nifty or Jr. Nifty, as closely as possible by investing in all the stocks that comprise that index in proportions equal to the weightage of those stocks in the index. These are passively managed funds wherein the fund manager invests the funds in the stocks comprising the index in similar weight. Index funds, while reducing the risk associated with the market, offer many benefits to the investors.

Firstly, the investor is indirectly able to invest in a portfolio of blue chip stocks that constitute the index. Next, they offer diversification across a multiplicity of sectors since index stocks are generally a basket of 20-25 sectors. Added to these is the relatively low cost of management. Index funds are considered appropriate for conservative long term investors looking at moderate risk, moderate return arising out of a well-diversified portfolio.