What is ETF – Benefits, Features, Working, Pros and Cons
ETFs (Exchange Traded Funds) offer all the advantages of mutual funds and tradable securities like stocks. They allow all the advantages of investing in passively-managed funds with the flexibility and ease of stock investments. These are a type of passive funds which you can buy and sell just like common shares.
If you want to invest in ETFs, read this blog so that you can make an informed investment decision.
What are ETFs?
Exchange-traded funds (ETFs) are a basket of financial securities that trade on a stock exchange. Many investment securities are pooled in to create an ETF, which then acts like a mutual fund. A few examples of ETFs are AXIS-Healthcare-ETF, Edelweiss-ETF-Nifty-100-Quality-30 and HDFC-Gold-ETF.
How Do ETFs Work?
Exchange-traded funds follow a passive investment strategy, mimicking an underlying benchmark index. In simpler terms, the portfolio of an ETF is identical to the composition of an index.
These funds are listed on major stock exchanges. Investors can buy and sell them during regular market hours. Similar to stocks, the price of ETFs changes constantly. The price of underlying assets, such as stocks, bonds, and more ascertains their value.
Let’s consider the example of the AXIS Technology ETF. It comprises equity shares of various companies belonging to the technology sector, such as TCS and Infosys. The NAV of the ETF depends upon the market price of these stocks.
Types of Exchange-Traded Funds
Here are the different types of ETFs in India:
1. Gold ETFs
By investing in gold ETFs, investors can participate in the bullion market without purchasing physical gold. The value of these ETFs increases when gold prices surge. Similarly, their value drops in case gold prices drop.
2. Equity ETFs
Equity ETFs are passively managed investment options that are based on stock indices. They invest in various securities in the same proportion as the underlying index.
Equity ETFs come with high transparency as they mirror their underlying index. Compared to mutual funds, equity ETFs have much lower expense ratios because of their structure and mechanism.
3. Debt ETFs
Debt ETFs are passively managed investment options that invest in only fixed-income securities in the same proportion as their underlying index. Debt ETFs have several benefits, such as high liquidity and transparency and low cost.
While, mostly, institutional investors choose to invest in debt ETFs, it is also becoming popular with retail investors.
4. Currency ETFs
These ETFs allow investors to take part in currency market transactions without investing in a particular currency. The objective of these financial instruments is to benefit from the price fluctuation in relation to an individual or a collection of currencies.
5. Bond ETFs
Bond ETFs provide exposure to both government and corporate bonds. These are suitable for investors who mitigate risk by diversifying their portfolios.
6. Commodity ETFs
Commodity ETFs invest either in agricultural/non-agricultural commodities or commodity futures. Often, commodity ETFs track indices representing only commodities like precious metals, agricultural products and natural resources.
Investments in commodity ETFs contribute to portfolio diversification and act as a hedge against inflation.
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7. International ETFs
International ETFs are passively managed funds that specifically invest in foreign-based securities. It may hold fixed-income securities or equities and can have its focus on a particular region or a specific country.
International ETFs may either track country-specific benchmark indices or global markets. Investors need to assess their risk profile before investing in international ETFs.
8. Sectoral/Thematic ETFs
While sectoral ETFs invest in companies of a specific sector, thematic ETFs focus on trends or themes. For instance, sectoral ETFs might focus on the energy industry as the underlying sector, while thematic ETFs focus on renewable energy.
9. Index Fund ETF
An index ETF enables individuals to invest in a collection of securities in one go. The aim of these financial instruments is to replicate the performance of a particular stock market index, for example, the Sensex or Nifty 50.
10. Liquid ETFs
Liquid exchange-traded funds minimize the risks of price fluctuations while generating higher returns by allocating funds to a collection of government securities with a low maturity period, such as overnight funds. Thus, at the same time, these ETFs ensure high liquidity for investors.
Benefits of Exchange-Traded Funds
The following are some benefits of investing in exchange-traded funds:
1. Low Cost Investment
In comparison to conventional mutual funds, exchange-traded funds have a much lower expense ratio. This is because fund managers of ETFs follow a passive investing investment strategy. Thus, it involves minimal management fees, which can have a positive impact on the overall net returns of investors. However, since investors have to buy and sell these financial instruments on a stock exchange, each transaction involves brokerage.
2. Portfolio Diversification
Exchange-traded funds enable investors to diversify their portfolios across different segments of the market. For example, one can get exposure to gold by investing in Gold ETFs.
3. No Lock-in period
ETF investments are liquid in nature; they do not have any lock-in period. Thus, investors can sell their holdings and raise funds to fulfil any urgent financial requirement that may arise.
4. Offers Flexibility
ETFs are traded on stock exchanges, unlike mutual funds. Thus, one may choose to buy or sell these financial instruments every day, similar to intraday trading.
5. Passive investing
Investors do not need to track the performance of all portfolio constituents of an ETF. The fund manager buys and sells the financial assets in the same proportion to replicate the performance of the underlying benchmark while ensuring minimal tracking error.
Disadvantages of Exchange-Traded Funds
Here are some disadvantages of exchange-traded funds:
1. Brokerage Fees
ETFs are traded on stock exchanges, similar to equity shares. Thus, one has to pay brokerage fees.
2. Requires a Demat Account
Although individuals can invest in ETFs on their own, they have to open a Demat account to execute the transaction.
3. Prone to Market Volatility
The shares of listed companies are subject to price fluctuations according to market trends. Thus, the performance of ETFs is heavily dependent upon the stock market scenario.
4. Portfolio Risks
The portfolio of ETFs exposes investors to different types of risks. For instance, if an individual invests in an ETF that tracks an international index, he/she is exposed to political risk. Whereas bond ETFs carry credit risk.
How to Invest in Exchange Traded Funds?
Given below are the steps to invest in ETFs:
Step 1: Open a trading account with a broker or a sub/broker and a Demat account to hold the ETF units. To complete these formalities, you must be KYC compliant and provide proof of identity, address and bank details.
Step 2: Select your first ETFs. Beginners can opt for index ETFs which are more reasonably priced than actively managed funds.
Step 3: To buy/sell ETFs, people can either use the telephonic mode, instruct the broker about what to do, or use the broker’s online trading platform. Also, don’t forget to check which stock exchange the broker is registered with.
How to Choose the Right ETF?
Investors need to consider these things before allocating their savings to ETFs:
1. Investment Time Horizon
Before investing in any financial instrument, it is crucial to identify the investment time horizon as it might directly impact investors’ financial goals. For instance, one can reduce his/her tax liability by investing in an ETF for a longer duration.
2. Investment Strategy
Individuals must make sure to formulate a clear investment strategy before investing in ETFs. They need to conduct a thorough analysis and figure out what should be the portfolio composition.
3. Tracking Error
In case an ETF has a high tracking error, it means that the fund manager is not able to replicate the performance of the underlying benchmark efficiently. One must make sure to avoid investing in such funds.
4. Costs
Although ETFs have a low expense ratio, investors must be aware of all the related costs, such as brokerage fees, rebalancing costs, and more.
Final Word
Exchange-traded funds can be an option worth considering for investors who are looking to diversify their investment in a specific geographical region, asset class, or sector. If individuals allocate their funds judiciously, they can minimize risk and improve their portfolio returns.
Nevertheless, one must make sure to consider certain key aspects, such as their risk appetite and financial goals before parting with their savings.
FAQs
Ans: In India, ETFs receive the same treatment as equity-oriented funds. Thus, short-term capital gains attract 15% tax. In contrast, the tax rate applicable on LTCG is 10%. Note that no tax is applicable on LTCG of up to Rs. 1 lakh.
Ans: ETFs that are managed by a fund manager is known as actively managed ETFs. All decisions regarding the ETFs are strategically made by fund managers.
Ans: ETF creation is the wrapping up of all underlying securities into one exchange-traded fund structure. While redemption is unwrapping an ETF into individual securities.
Ans: The main difference between an ETF and an index fund is that ETFs can be bought and sold during the day, while index funds can only be bought and sold at a set price at the end of the trading day.
Ans: Yes, investors can opt for a SIP for their ETF investments by using their Demat account.
Ans: No, ETFs have a lower expense ratio in comparison to debt funds as they follow a passive investing strategy, unlike the latter. The maximum total expense ratio (TER) of an ETF can be 1%. That said, the maximum permissible TER of a debt fund is 1%.
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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.
