Exchange Traded Funds (ETFs): Meaning, Types, Benefits & How To Choose ETFs
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16 April 2022Exchange-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 mutual fund. A few examples of ETFs are AXIS-Healthcare-ETF, Edelweiss-ETF-Nifty-100-Quality-30 and HDFC-Gold-ETF.
If you want to invest in ETFs, here’s how they work, their types, benefits, disadvantages and how to choose the best ETF. Read on!
Table of contents
How Do Exchange-Traded Funds 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.
Also Read – Difference between direct mutual funds and regular mutual funds
What are the Different Types of Exchange-Traded Funds?
Here are the different types of ETFs in India:
Index Funds 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.
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.
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.
Bond ETFs
Bond ETFs provide exposure to both government and corporate bonds. These are suitable for investors who mitigate risk by diversifying their portfolios.
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:
- Low cost of 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.
- 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.
- 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.
Also Read – Easy Ways To Invest In Mutual Funds Online
- 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.
- 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.
- Transparency
While mutual funds have to disclose their holdings every quarter, ETFs disclose their portfolio constituents on a daily basis.
Disadvantages of Exchange-Traded Funds
Here are some disadvantages of exchange-traded funds:
- Brokerage fees
ETFs are traded on stock exchanges, similar to equity shares. Thus, one has to pay brokerage fees.
- Requires a Demat account
Although individuals can invest in ETFs on their own, they have to open a Demat account to execute the transaction.
- 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.
- 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 Select Exchange-Traded Funds?
Investors need to consider these things before allocating their savings to ETFs:
- 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.
- 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.
- 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.
- 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 on Exchange-Traded Funds
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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