What does the commonly used acronym ETF mean and why are ETFs associated with the term passive investment?

By Koel Ghosh, ETF Junction

Monday september 11, 2023

The Indian investment landscape has been transforming with portfolios including different investment styles and products. One such product class that is now gaining ground are Exchange Traded Funds (ETFs). Exchange Traded Funds are often associated with passive investing. This means that there is no requirement of a fund manager to take decisions on which securities are a part of the fund. When fund managers are involved in the day-to-day inclusion of securities, that is called active management which involves the fund managers expertise in securities selections along with many a times having a research team aiding the process.

Let’s understand why Exchange Traded Funds, ETFs- a commonly used acronym are termed as passive investing. One simple explanation, they are not active. They replicate an index, which means that investment style will be one that will mimic the index in the same construct as the index. We are aware of many indices in India like the Nifty, Sensex, Bank index, auto index, etc. To further explain how replicating the index works with an example, say we have a bank index as below with the following weightages per security

The exchange traded fund will invest the portfolio in the same proportion as the index. So, for example, Investor X has INR10,000 to invest, the ETF will invest that amount in the same proportion as the index. Hence the below is how the amount will get divided,

Hence concluding on why passive is used as an association for ETFs, there is no security selection required which is associated with active management. There are immense advantages with ETFs

• Lowering risk of concentration If an investor were to buy one security, the concentration is higher. In an index there are a basket of securities which spreads the portfolio or investment over the various securities
• Diversification A follow on to the lower concentration is diversity. There are various indices. An index like the Nifty or SENSEX comprise of 50 and 30 stocks respectively. Not only do they represent the country, the stocks are spread over different sectors. Hence any portfolio or investor has exposure across stocks and sectors providing wider exposure
• Flexibility ETFs are traded on the stock exchange. This offers liquidity and the ability for investors to invest any time during trading hours
• Lower Cost Another benefit in ETF investing is due to the passive nature, the cost of fund management and research in not incurred allowing the product to offer lower expense ratio compared to other active products like mutual funds which incur higher expenses due to fund manager and research costs
• Unbiased index As the indices that are underlying the ETFs or the basis of the portfolio of the ETFs are based on index by independent index providers there is no bias. Index providers do not create products or have any interest in the objective of the index other than creating diverse indices to offer more solutions to the market.

In summary, ETFs are simple options available for investors to invest in a theme, country, sector or asset class. There are various investment strategies that can include ETFs as either a part or comprise entirely of ETFs. ETFs are increasingly gaining ground in passive strategies both in India and globally.

Disclaimer: Mutual Fund Investments are subject to market risks.Read all scheme related documents carefully