Exchange Traded Fund (ETF) is an investment fund, listed and traded on the stock exchange just like stocks. It is security involving a collection of securities like stocks that often tracks the underlying index, however, they can use different strategies or invest in any number of industry sectors. Exchange Traded Funds are similar to mutual funds in many ways with the only difference being they are listed on exchanges and investors can trade in them throughout the day just like stocks.
What are ETFs composed of?
ETFs are composed of assets like stocks, bonds, commodities. As they are composed of multiple assets rather than one, they can be a great choice for diversification. Generally, they operate with an arbitrage mechanism designed to keep them traded close to the net asset value. Most ETFs track an index such as the bond index or stock index. They are an attractive investment because of their tax efficiency, stocks like features, and low costs. An Exchange traded fund can own hundreds of stocks across different sectors or can also be isolated to only one sector or industry.
How ETFs Work?
ETF possesses the characteristics of both mutual funds and shares. Generally, they are traded in the stock market as shares produced via creation blocks. They are listed on all major exchanges and can be bought and sold during the equity trading time as required. The change in the price or Net Asset Value (NAV) depends on the cost of the underlying assets in the pool. If the price of one asset increases, the NAV/price of ETF rises, and vice versa.
The value of the dividend received by the ETF holders depends on the performance and asset management of the ETF Company. ETFs can be managed actively or passively as per the norms of the company. Actively managed exchange traded funds are operated by the portfolio managers after assessing carefully in the stock market and undertaking calculated risk by investing in the high potential companies.
On the other hand, passively managed ETFs follow the underlying market indices trends, investing in the companies listed on the rising charts.
Types of ETFs
The most common types of ETFs are:
- Equity ETF: These types of ETFs represent companies that invest in shares and other equity of different companies.
- Gold ETF: Gold ETFs are commodity funds primarily involving gold assets. Purchasing gold ETFs allow you to become an owner of gold in papers without having to worry about asset protection.
- Debt ETF: Trading in fixed return securities like government bonds and debentures are normally called Debt ETFs.
- Currency ETF: Currency ETF profit mainly due to the fluctuation of currency exchange rates. The companies purchase currencies based on calculated predictions about the currency’s future performance. Currency ETFs not only follow the trends in the stock exchange but also the economic and political scenario of the counties.
- Index ETF: These types of ETFs have returns similar to the benchmark indices. This means that the price fluctuations in the Index ETFs are linked directly to the underlying index as the ETF will be composed of shares that proportionately reflect the securities of the underlying index.
Why Should a Retail Investor Invest in ETFs?
Purchasing shares of a company keeps the retail investors limited to the company’s performance, subjecting to a higher risk. Whereas, investing in Exchange Traded Funds allow the investors to keep their investments spread over assets of multiple sectors, significantly diluting the risk. Even if one of the assets underperform from the basket of resources, growth in other assets can compensate for the loss.
The cost-efficiency of ETF is the biggest advantage a retail investor can benefit from. The expense ratio of ETF is generally less than 0.5% as compared to 2.5% for equity funds. A lower fund management fee will generate incremental savings that can generate increased payouts in the end. Moreover, ETFs have reduced expenses as compared to mutual funds as mutual funds involve expenses like management fee, entry and exit load, etc. This cost will increase the total cost incurred and the total expense ratio of mutual funds. As exchange traded funds are traded like equity in the stock market, their expense ratio is lower.
As these funds track the underlying index, you know the components and the amount for each of the components. For example, Nifty 50 will be composed of 50 companies listed in the index. An Exchange Traded Fund tracking Nifty 50 will hold the same companies in the same amount. When the Index compositions change, the ETF will also rebalance the holdings.
Since the ETFs are marketable, they can be traded easily on the exchanges. Retail investors can buy and sell ETF at any time during the trading hours. ETFs are more liquid as compared to investments like PPF and mutual funds. This is because the NAV/price of an ETF fluctuates throughout the day while mutual funds are usually traded directly with fund houses at the declared NAV of the day.
Since these funds track underlying indices, the retail investors don’t have to rely on investment calls provided by the fund managers. Hence the trading in ETFs is not affected by the fund manager’s errors. There can be an error in tracking the index, known as tracking error.
In India, ETFs track diverse products such as Gold, Nifty 50, Nifty Low Vol 20 Index, and others. Whereas, you may not find mutual funds that track all these assets.
Limitations of ETFs
Limited Upside Growth
Only mature companies make it to the indices such as Sensex or Nifty. Such indices only include large-sized companies and most companies have put behind their best growth years behind them. Hence, investing in ETFs cannot tap the opportunities to earn high returns in high growth potential small and mid-cap companies
Trading and Demat account Required
Investors need to have a Demat and trading account to invest in the ETFs. Many mutual fund investors don’t have a Demat and trading account since these accounts are not required for investing in mutual funds.
Giving up Alpha
When investing in ETFs, investors are giving up the potential to outperform since the investor is tracking the index only passively. An actively managed fund will not only give index returns to the investors but will also beat the alpha.
The Best ETF to Invest in?
Index ETFs are the best ETFs where a retail investor can look to invest. An Index ETF will be composed of all the stocks listed in the benchmark index in the exact proportion. Hence, the risk will be minimum and the retail investor will also be able to invest in a pool of shares. When the composition in the Index changes, the holdings in the ETF will also be modified accordingly.
With Index ETFs, the portfolio of a retail investor will not be limited to just one or two stocks but a bunch of stocks registered under the benchmark stock. This will reduce the risk associated with buying stocks of only a few companies.
|Fund Name||1Y Returns(%p.a)||Expense Ratio(%)|
|Motilal Oswal NASDAQ 100 ETF.||26.25||0.55|
|HDFC Sensex ETF||-15.25||0.05|
|Edelweiss ETF – NQ30||-16.15||0.3|
|SBI – ETF Sensex||-15.2||0.08|
Young investors who are not quite familiar with the intricacies of the stock market can try their hands on the low-risk Exchange Traded Funds that track the broader market. Sectoral funds enable the retail investors to take bearish or bullish positions in specific sectors while leveraged ETFs and inverse ETFs allow advanced portfolio management strategies. Features like liquidity, diversification, low fee, and innovation make ETFs an ideal investment option for young retail investors.