Exchange-Traded Funds (ETFs)

Exchange-Traded Funds (ETFs) are marketable investment instruments that track an underlying index, commodity, sector, or asset class and are traded on stock exchanges like ordinary shares. Combining features of mutual funds and equities, ETFs have emerged as an important financial innovation in modern banking and finance. In the Indian economy, ETFs have gained increasing prominence as cost-efficient, transparent, and flexible investment vehicles supporting capital market development and financial inclusion.

Concept and Basic Structure

An Exchange-Traded Fund is a pooled investment vehicle that holds a basket of assets designed to replicate the performance of a specific benchmark, such as a stock index, bond index, or commodity price. Unlike traditional mutual funds, ETFs are listed and traded on stock exchanges throughout the trading day at market-determined prices.
ETFs are typically passively managed, aiming to mirror the returns of the underlying index rather than outperform it. This passive structure results in lower management costs and reduced portfolio turnover.

Key Features of ETFs

Exchange-Traded Funds possess several distinguishing characteristics:

• Intraday tradability, allowing investors to buy and sell units during market hours.
• Transparency, as portfolio holdings are disclosed regularly.
• Low expense ratios, due to passive fund management.
• Liquidity, supported by market makers who provide continuous buy and sell quotes.
• Diversification, even with relatively small investments.

These features make ETFs suitable for both retail and institutional investors.

Types of Exchange-Traded Funds

ETFs are available in multiple forms depending on the underlying asset:

• Equity ETFs, tracking stock indices such as broad market or sectoral indices.
• Debt ETFs, investing in government securities or corporate bonds.
• Commodity ETFs, linked to assets such as gold.
• International ETFs, providing exposure to foreign markets.
• Thematic and sectoral ETFs, focusing on specific industries or investment themes.

In India, equity and gold ETFs have been the most widely adopted.

Role in Banking and Financial Markets

ETFs play a significant role in modern banking and finance by enhancing market efficiency and liquidity. Banks and financial institutions use ETFs for portfolio diversification, hedging, and asset allocation strategies. ETFs also serve as effective tools for managing short-term liquidity and market exposure.
From a systemic perspective, ETFs deepen capital markets by increasing participation and linking savings to productive investments. Their transparent pricing contributes to better price discovery in underlying securities.

Growth of ETFs in the Indian Economy

In India, ETFs have gained momentum with the development of organised capital markets and increased investor awareness. Stock exchanges such as the National Stock Exchange of India and the Bombay Stock Exchange provide platforms for ETF trading, ensuring regulatory oversight and settlement efficiency.
Government initiatives, including the use of ETFs for disinvestment of public sector enterprises, have further popularised ETFs among retail investors. Gold ETFs, in particular, have offered an alternative to physical gold, helping reduce imports and improve balance of payments management.

Regulatory Framework and Investor Protection

ETFs in India operate under a well-defined regulatory framework. The Securities and Exchange Board of India regulates ETF issuance, disclosure norms, and trading practices to protect investor interests.
Banks distributing ETF products must adhere to suitability and disclosure requirements, ensuring that investors understand risks related to market fluctuations and tracking errors.

Advantages and Limitations

ETFs offer several advantages, including cost efficiency, flexibility, and ease of access. They are particularly suitable for long-term passive investors and institutions seeking market-linked returns.
However, ETFs also have limitations. Market price deviations from net asset value, liquidity constraints in less popular ETFs, and exposure to overall market risk can affect returns. Unlike actively managed funds, ETFs do not provide downside protection during market downturns.

Implications for the Indian Financial System

ETFs contribute to financial deepening by broadening investment choices and promoting a shift from physical to financial assets. They support household participation in capital markets and align with broader goals of financial literacy and inclusion.
For banks, ETFs represent an important product category in wealth management and treasury operations, while for policymakers they serve as instruments to mobilise savings and improve market efficiency.