An ETF is built by investing in a collection of assets based on a benchmark index. Traders can buy units of these funds just like company stocks, with trading happening on a stock exchange throughout the day.
These funds function as a basket of investments traded on the exchange. The provider pools assets like stocks or bonds and offers shares to investors. While investors own a portion of the fund, they don’t directly own the underlying assets. Funds tracking a stock index can also distribute dividends, similar to the companies within the index.
Types of ETFs
Discussed below are the various types of Exchange Traded Funds:
1. Equity ETF
Equity ETFs are described as passive investment options combining the features of stocks and equity mutual funds. Investors can trade these funds on stock exchanges, namely the NSE (National Stock Exchange) or BSE (Bombay Stock Exchange). They can purchase or sell these funds at market prices on a real-time basis.
While the minimum investment quantum is one unit, there is no specification regarding the minimum investment amount. Equity ETFs are cost-effective and provide transparency regarding their holdings.
2. Bond ETF
Through bond ETFs, investors receive exposure to various fixed-income instruments such as Government bonds (with different maturities) and debentures. These ETFs combine the features of stock investments with the benefit of debt investments and the simplicity of mutual funds. People can trade bond ETFs on the open cash market.
3. Commodity ETF
Gold and silver ETFs are the only commodity ETFs available in India right now. These are passively managed funds tracking an underlying market index. The NAV (Net Asset Value) of commodity ETFs is subject to change throughout the day. The movement in prices depends on the demand and supply of the commodity in the markets.
4. Sectoral/ thematic ETF
A sectoral or thematic ETF tracks the performance of a particular sector or theme. A sectoral Exchange Traded Fund invests in a specific industry, such as banking, pharmaceuticals, and real estate. A thematic ETF focuses on an idea that encompasses multiple sectors like consumption or ESG (Environmental, Social, and Governance).
5. International ETFs
International Exchange Traded Funds replicate the index of a foreign country or that of the global market. These ETFs provide the opportunity to invest directly in foreign companies. They are similar to international mutual funds. Investors could use such ETFs to diversify the political and geographical risks associated with their portfolios. The price determination depends on the region-specific timelines and takes place at the end of the day.
6. Index ETFs
Index ETFs are designed to replicate the performance of a specific market index, such as the Nifty 50, Sensex. Investors who believe in the overall performance of the market can invest in these ETFs without the need to select individual stocks. Index ETFs offer broad diversification and are often considered a passive investment strategy.
7. Fixed Income ETFs
For investors seeking exposure to the bond market, fixed income ETFs provide a convenient and diversified option. These ETFs track various bond indices, including government bonds, corporate bonds, and even international bonds. They offer a way to invest in fixed-income securities without the need for extensive research and portfolio management.
8. Leveraged ETFs
Leveraged ETFs employ leverage to amplify the returns of the underlying index. This means that these ETFs can generate significantly higher returns than the index during periods of market growth. However, it's important to note that leverage can also magnify losses during market declines. Leveraged ETFs are suitable for experienced investors who understand the risks associated with leverage.
9. Style ETFs
Style ETFs target specific investment approaches or market segments. For example, large-cap value funds invest in big companies with undervalued stocks, while small-cap growth funds focus on smaller firms with high growth potential. These options help investors align their portfolios with specific strategies or sectors.
10. Foreign Market ETFs
Investors looking to gain exposure to international markets can do so through foreign market ETFs. These ETFs track indices of foreign markets, such as the Nikkei 225 in Japan or the Hang Seng Index in Hong Kong. They offer a convenient way to diversify portfolios and participate in the growth of global markets.
11. Inverse ETFs
Inverse ETFs are designed to profit from a decline in the underlying market or index. They move in the opposite direction of the underlying asset. These ETFs can be used as a hedging tool or to speculate on a declining market. However, it's crucial to understand the risks involved and use them cautiously.
What things to consider before investing in ETFs
With their hybrid nature, ETFs combine features of both stocks and mutual funds. To use them effectively, investors should understand both asset types. These funds offer flexibility in investment planning and diversification across different securities. However, proper research is key to making the most of these investments.
1. Analysing underlying assets
ETF performance is directly linked to the underlying assets they track. Investors should conduct a thorough analysis of these assets, considering factors such as risk, return, volatility, investment horizon, alignment with financial goals, and desired portfolio allocation. This DIY approach is particularly suitable for confident investors seeking convenient exposure to specific asset classes.
2. Evaluating bid-ask spreads
In stock exchanges, buyers and sellers engage in bidding and asking for securities. The difference between the bid and ask prices, known as the bid-ask spread, indicates the ETF's liquidity. A narrow spread signifies high liquidity, implying ample trading activity and ease of buying and selling ETF units. Conversely, a wide spread suggests lower liquidity.
3. NAV vs iNAV
While ETFs are priced through bid-ask spreads, they share a similarity with mutual funds in net asset value (NAV). Mutual funds determine NAV at the end of the trading day, reflecting asset values. In contrast, ETFs use an Indicative Net Asset Value (iNAV), calculated similarly but updated throughout the day. Investors can compare the asking price with iNAV to check for fair pricing and track performance.
4. Considering costs
ETFs generally have lower expense ratios than actively managed mutual funds due to their passive management approach. However, investors should factor in additional costs such as trading fees and demat account maintenance charges. If a demat account is not already in place, the costs associated with opening and operating one, as well as the quality of broker services, should be considered.
5. Understanding tax implications
To make informed investment decisions, investors should be aware of the tax treatment of ETFs. ETFs are categorised into equity and non-equity (debt, commodity, and international) types for tax purposes, impacting their tax implications.
How to buy and sell ETFs?
Given below are steps to purchase units of an ETF:
Step 1: Open a Demat and trading account with an online brokerage firm. Before that, conduct thorough research and decide on the fund to invest in.
Step 2: A variety of options will be available depending on the AMC (Asset Management Company). Insert the correct symbol and number of shares to purchase.
Step 3: Depending on the preferred ETF transaction, place an order and click on ‘submit’. After the completion of the deal, the investor will receive an order update.
Investors can sell exchange traded fund sthroughout the day. It enables them to benefit from intraday price changes. This is in stark contrast to mutual funds, where investors can make a purchase or redemption only at the end of a trading day.
Pros and cons of ETFs
The benefits and limitations of investing in ETFs are given in this section:
Pros
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Cons
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Ease of understanding: Investment returns are straightforward and transparent.
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Limited outperformance: ETF returns are tied to the underlying index, limiting potential for outperformance.
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Risk mitigation: Passive investment strategy helps reduce unsystematic risk and overall investment risk.
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Liquidity concerns: ETF trading can be affected by the liquidity of the underlying units.
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Diversification: ETFs offer a simple way to diversify a portfolio.
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Non-efficiency: Some consider ETFs less efficient due to their index-tracking nature.
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Cost-efficiency: Limited fund manager involvement reduces costs compared to actively managed funds.
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Limited flexibility: Fund managers cannot deviate from the index weightage, limiting portfolio customisation.
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Benefits of investing in ETFs
ETFs offer several advantages over traditional mutual funds:
- Trading flexibility: Unlike mutual funds, which are typically traded at the end of the day, ETFs can be bought and sold throughout the trading day, similar to stocks.
- Transparency: Most ETFs are required to disclose their holdings daily, providing investors with clear visibility into the underlying assets.
- Tax efficiency: ETFs often have lower turnover rates than actively managed funds, which can result in fewer capital gain distributions and lower tax implications for investors.
- Trading strategies: Investors can employ various trading strategies with ETFs, such as limit orders and stop-loss orders, which are not typically available with mutual funds.
Conclusion
ETFs provide an easy entry point for investing in specific asset classes, industries, regions, or currencies, simplifying the process for investors who may not have the time or expertise for in-depth research. Their low-cost structure makes them well-suited for long-term investment strategies. However, due to the increasing variety of ETFs available, investors should carefully select funds that match their individual investment objectives and risk tolerance.
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