An exchange-traded fund (ETF) is a type of investment fund that can be bought and sold on a stock exchange, making them similar to individual stocks. ETFs are a common way for investors to diversify their portfolios as they pool money from investors to purchase a variety of financial assets, such as stocks, bonds, currencies, and commodities. Investors who buy shares in an ETF gain a portion of the fund's profits and any residual value if the fund is liquidated. ETFs can be structured as corporations, trusts, or other legal entities. All ETFs are subject to regulations outlined in the Securities Act of 1933 and the Securities Exchange Act of 1934.
What are Exchange-Traded Funds (ETFs)?
An Exchange-Traded Fund (ETF) is a type of marketable security that resembles a mutual fund but can be traded on an exchange as its name indicates. Like mutual funds, ETFs also invest in a basket of different assets. Depending on the type of assets predominantly chosen for the portfolio, ETFs may be equity-oriented, debt-oriented or even hybrid funds.
ETFs are commonly designed to track specific benchmarks and indexes in the market like the Nifty, Sensex and a whole range of other sectoral, thematic or market-cap-based indexes. They may also invest in a portfolio of bonds, commodities or other securities, depending on the index being tracked.
Advantages of ETFs
Now that you know how these investment vehicles work, let us take a closer look at the key advantages of Exchange-Traded Funds for investors.
- Liquidity
One of the defining benefits of ETFs is that they can be easily traded on stock exchanges, just like regular equity stocks. So, you can buy ETFs or sell your ETF holdings at any time during business hours. That said, some ETFs may be less liquid than others, depending on the demand. So, you need to be mindful of the liquidity of the Exchange-Traded Funds that you have chosen to invest in and adjust your investment strategy accordingly. - Affordability
Another major advantage of Exchange-Traded Funds is that they are extremely cost-effective. Since they are designed to track an index, they follow the passive style of investment, which eliminates many of the costs associated with active fund management. This results in lower expense ratios for ETFs overall, so the net returns from these funds are not reduced greatly due to investment costs. - Diversification
Since ETFs track indexes, they offer the advantage of inherent diversification. Each index is generally a group of stocks or other securities. So, Exchange-Traded Funds have a mix of different securities in their portfolios. Achieving the same level of diversification by choosing stocks and securities individually for your investment portfolio can be cumbersome and costly too. - Accessibility
If you are planning to purchase ETFs, there are no minimum investment limits that you need to worry about. This leads us to the next advantage of Exchange-Traded Funds, which is that they are highly accessible to traders and investors with varying budgets and financial capacities. Also, since ETFs track different types of indexes, you can find an Exchange-Traded Fund for any kind of risk appetite. - Tax advantages
ETFs offer potential tax benefits compared to traditional mutual funds. When a mutual fund sells underlying securities within the fund, it may generate capital gains that are then distributed to shareholders, even if the shareholder hasn't sold their shares. This can result in a tax burden even if the investor hasn't profited from selling their ETF shares themselves. ETFs, however, typically experience less internal trading due to their structure. This minimizes capital gains distributions within the fund, potentially reducing your tax liability. - Transparency
ETFs offer a high level of transparency to investors. Unlike mutual funds, which disclose holdings periodically, most ETFs publish their holdings daily. This allows investors to see exactly what assets the ETF is invested in and how their holdings are distributed. This real-time insight empowers investors to make informed decisions about their investments. - Wide menu of investment options
The vast array of ETFs available caters to diverse investment goals and risk tolerances. Investors can choose from ETFs that track broad market indexes like the S&P 500 or focus on specific sectors like technology or healthcare. There are also ETFs that target specific investment strategies, such as dividend-paying stocks or socially responsible companies. This extensive selection allows investors to tailor their investment portfolio to their unique financial goals and risk appetite..
How do ETFs work?
To better understand the advantages of Exchange-Traded Funds, you need to first have clarity about how they work. The creation of the fund’s portfolio works similarly to how mutual fund portfolios are created. However, unlike regular mutual funds, ETFs can traded like equity stocks on the bourses.
Since ETFs are structured like mutual funds, they are also taxed in the same way. This means debt-oriented ETFs are taxed like debt funds and equity-oriented ETFs are taxed like equity funds. Also, since ETFs typically track an index, they are passively managed assets. This distinct feature results in many advantages of ETFs for investors, as you will see in the following section.
What are the considerations when investing in ETFs?
When considering investing in ETFs, it's crucial to understand the various factors that can impact your investment experience. These considerations can be broadly categorized into five key areas:
Category |
Description |
Commissions |
Some brokerage firms charge a commission when you buy or sell an ETF. Over time, these commissions can add up and become a significant cost. However, some brokers like Schwab offer commission-free ETF trading. Always check with your broker before trading. |
Spreads |
In addition to commissions, investors also pay the "spread" when buying or selling ETFs. The spread is the difference between the higher price you pay to acquire a security and the lower price at which you can sell1 it. A wider spread translates to higher costs. |
Premiums and Discounts |
ETFs are bought and sold at market prices, not at their Net Asset Value (NAV) like mutual funds. As a result, investors may pay more for an ETF than the value of its underlying stocks or bonds (a premium) or sell an ETF for less than the value of its holdings (a discount). |
General Liquidity |
An ETF's liquidity is determined by the number of market makers willing to buy or sell the ETF throughout the trading day. Higher liquidity generally leads to narrower bid-ask spreads, while lower liquidity ETFs tend to have wider spreads. |
Market Volatility |
Market volatility can impact ETF spreads. Increased volatility may lead to wider bid-ask spreads and can also affect premiums or discounts to net asset values, resulting in higher costs for the investor. |
Complexity |
Some ETFs may be more complex or lack diversification due to their strategies or holdings. It's essential to carefully evaluate an ETF's features, risks, benefits, and performance characteristics before investing. |
Key takeaways
- ETFs provide convenient access to diversified portfolios.
- They trade throughout the day, offering flexibility.
- ETFs generally have lower expense ratios than mutual funds.
- Mutual fund fees have recently decreased, narrowing the gap.
- ETFs offer daily transparency into their holdings.
- There are also some potential drawbacks to consider.
Conclusion
Now that you know the advantages of ETFs, you can make an informed decision about including them in your investment portfolio. If you want to tide over the limitations of ETFs, you can also consider investing in mutual fund schemes. Check out the 1,000+ mutual funds available on the Bajaj Finserv Mutual Funds Platform to find the right fit for your goals.
You can even compare mutual funds on this platform and streamline your investment decisions using tools like a SIP calculator, which can be particularly useful if you want to make SIP investments in mutual funds.
