What are Index Exchange Traded Funds – Benefits and How to Invest
Exchange-Traded Funds (ETFs) are passive investment instruments that mimic an underlying index. In other words, the portfolio of an ETF has an identical composition to a specific index. You can buy and sell ETFs on stock exchanges. Index ETF is the type of ETF that’s most popular amongst investors.
What is an Index ETF?
Index ETFs are those ETFs that closely follow specific stock market indices such as Sensex, Nifty 50, Bank Nifty or others. When you invest in an index ETF, you buy a share or a part of a portfolio that consists of securities of the index that an exchange-traded fund is following or replicating.
These are passively managed funds and are similar to index mutual funds. However, in the case of index mutual funds, you can redeem the units once each day when the trading closes. The pricing takes place on the basis of the NAV of underlying securities. But you can buy index exchange-traded funds throughout the day.
Types of Indices
Here are some of the different types of indices:
- Benchmark indices
Benchmarks are flagship indices, and it reflects the overall functioning of the economy and markets. They use some of the best-known methodologies to regulate the companies listed on them.
India has two benchmark indices – NSE Nifty 50 and BSE Sensex. The former is a collection of 50 top-performing stocks, and the latter is a collection of top 30 performing stocks. These benchmarks give a view of the overall state of the Indian economy. - Sectoral indices
There are many sectoral indices that comprise stocks from a particular sector and give an idea about its functioning. The most popular sectoral index is Bank Nifty which consists of stocks of leading banking organisations in India. Other sectoral indices on NSE and BSE include BSE Healthcare, NSE Pharma, BSE PSU, Nifty PSU Bank, etc. - Market cap-based indices
These are indices based on the market capitalisation of a company. Market cap is the total value of a company listed on stock exchanges. A market cap-based index like S&P Nifty Smallcap 100 contains 100 top-performing small-cap stocks.
How to Invest in Index ETFs?
The process of investing in this type of Exchange-Traded Fund is quite similar to stock investing. Index ETFs, as mentioned, trade on stock exchanges just as any stock does. So, if you are interested in investing in index ETFs, you need to have a Demat account. You can buy, sell or hold units of an index ETF just like a stock.
Exchange-Traded Funds provide excellent diversification as compared to investing in a single stock. You can benefit from higher flexibility to invest throughout the sectors, asset types, regions and markets. They also offer high liquidity, making it easier for you to enter or exit the positions.
In case you are looking for similar passive investment options, you can consider investing in index funds. Navi offers various index funds such as Navi Nifty Bank Index Fund, Navi Nifty 50 Index Fund and more. You can enjoy hassle-free and convenient investing with lower charges and fees. Download the Navi app to explore the different options!
Also Read: Best Index Funds To Invest In 2022
Benefits of Investing in Index ETFs
Index ETFs are suitable investment options regardless of your investment horizon. If you are into long-term investing, exchange-traded Funds provide diversification to a portfolio, which mitigates portfolio risk. However, if you have short-term investment goals, these can offer liquidity as they take part in intra-day trading. Moreover, the initial investment is relatively lower.
Here are some of the benefits that you can receive by investing in index ETFs:
- You can buy or sell exchange-traded funds any time throughout the day at the current price.
- Index ETFs closely monitor and track index performance. This allows you to seize any trading opportunity arising throughout the day.
- Unlike index mutual funds, index Exchange-Traded Funds come with lower tracking error.
- Investment in index Exchange-Traded Funds also helps with hedging risk since you can borrow and sell short.
Index ETF vs Mutual Funds vs Stocks
Here are the differences between index ETFs, mutual funds and stocks:
| Parameter | Index ETF | Mutual Funds | Stocks |
| Working | One can buy and sell units of index ETF on a stock exchange. | Investors cannot buy or sell mutual fund units on stock exchanges. | One can trade them on stock exchanges. |
| Lock-in period | ETFs do not come with a minimum lock-in period. | Some mutual fund schemes do come with a minimum lock-in period. | Stocks do not have any lock-in period. An investor can buy or sell the same at their convenience. |
| Liquidity | ETFs can easily be traded on stock exchanges; hence they have higher liquidity than mutual funds. | Mutual funds have lower liquidity in comparison to stocks and ETFs. | Stocks generally have very high liquidity. Their degree of liquidness depends on the kind of stock being sold. |
| Type of investment | An index ETF follows an index and tries to replicate its performance. Hence, they are passively managed. | A mutual fund may be actively or passively managed as per the working of these funds. | Stocks are always actively managed. Investors put in a lot of hard work and market research to select the right stock for investment. |
Things to Consider Before Investing in Index ETFs
If you are planning to invest in index ETFs, you need to keep the following vital pointers in mind:
- Expense Ratio
The expense ratio is the charge that fund houses impose on you to cover the fund’s operating expenses. The expense ratio includes administration fees, management fees, auditing, brokerage, re-balancing cost, and more. Since index ETFs are passively managed funds, the expense ratio is comparatively lower. However, you should learn about all the charges and fees associated with an ETF. - Risk
Like all other investment instruments, Exchange Traded Funds come with a certain degree of risk. Make sure to determine your own risk appetite and then invest accordingly. Unfavourable developments in the sector or market in which ETFs are invested can pose a significant risk. - Investment Strategy
The financial goals of all investors are not the same. You need to have a clear investment strategy before you start investing in any of the exchange-traded funds. - Investment Horizon
Before investing in ETFs, you should know about your investment horizon. Index Exchange-traded funds are beneficial for both long-term and short-term horizons. Long-term investment offers the benefit of reduced tax liability. - Liquidity
Liquidity is an essential factor you should consider before investing in any exchange-traded fund. This is because ETF units must be bought or sold on stock exchanges. ETFs that are not quite liquid will not get enough buyers at the time of selling. - Tracking Error
Tracking error is the difference between the returns of an ETF and that of the index it is tracking. This is a crucial factor since you would be investing in an index through an Exchange Traded Fund.
Also Read: Things To Know Before Choosing A Mutual Fund Scheme In India
Final Word
Index ETFs can be an excellent investment option as they provide higher chances of diversification and liquidity. However, you have to pay a fee to your broker every time you carry out a transaction. In addition, you need to be aware of STT, expense ratio and other charges to make an informed decision.
FAQs
Ans: No, you cannot invest in an index ETF without opening a Demat account with a stockbroker. Index ETFs require buying and selling throughout the day, which isn’t possible without a Demat account.
Ans: Index exchange-traded funds derive their liquidity from trading of units in secondary markets and then by in-kind or redemption process. The liquidity of an index exchange-traded fund is basically the liquidity of underlying securities.
Ans: When securities of the underlying index change, the fund will also change the securities of its portfolio. It will sell those securities that have been removed from an index and add those that have been included in it.
Ans: Index Exchange Traded Funds are open-ended schemes that follow different indices and replicate their returns. These are also passively managed funds. Fund managers of ETFs are not actively involved in the investment decisions; they buy and sell securities as per the changes taking place in the underlying index.
Ans: ETFs generally reinvest the dividends received from companies back into the fund. They do not give dividend payouts to investors. However, some funds may pay dividends to their investors instead of reinvesting them.
Ans: Index Exchange-Traded Funds are suitable for fulfilling long-term financial objectives. Hence, investors must remain invested in these funds for at least 7-10 years for any meaningful return or wealth accumulation.
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Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
