Understanding ETFs As An Investment Option

If you have not heard about ETF, don’t worry! ETF is a comparatively new concept introduced to the Indian financial market. ETF stands for exchange-traded funds, which allows you to invest in different asset classes as a basket. If you are aware of mutual funds, where you invest in a portfolio rather than individual stocks, you will find ETFs easier to understand. However, there are certain differences between ETF and regular mutual funds, or ETF and general stocks, which we will eventually discuss in this article. To know what an ETF is and why you must know about it, kindly read on.

ETFs are unique investment tools, used to formulate various trading strategies for the underlying assets.  ETFs allow investors to participate in a variety of asset classes collectively without increasing risk exposure manifold. Because of its unique features, high liquidity, and low costs, ETFs have earned a niche in the capital market and are granted as a great tool for portfolio diversification.

What are ETFs?

We can consider an ETF as a basket that holds several securities that tracks an underlying asset, in this case, exchange indices. By nature, it is close to mutual funds, but listed with the exchanges and traded in the market like stocks. It is an index fund that follows a benchmark index irrespective of market movement.

An ETF is like a portfolio, containing different types of investments – stocks, commodities, bonds, and more, to create a well-balanced basket. An example of a popular ETF is SPDR S&P 500 ETF (SPY), which tracks the S&P 500 index. ETF funds are highly liquid, and prices of these funds move with the market trends. This allows investors to buy or sell them any time during trading hours.

ETF funds were introduced in India in 2001.  The first ETF was NIFTY BEES (Nifty Benchmark Exchange Traded Scheme) based on NIFTY 50 launched by Benchmark Mutual Funds.

Depending on underlying asset class ETFs are of six types.

Gold ETFs– Are a type of commodity ETFs that mainly follow gold as an underlying asset

Sector ETFs– The other name of it is Industry ETFs. It tracks a particular industry, such as technology, energy, or finance.

Bond ETFs– It includes government bonds, or other typical investment tools that qualify as bonds.

Currency ETFs– It allows you to invest in foreign currencies like EURO or Dollar

Inverse ETFs– It involves a practice called shorting of stocks, which means selling shares that are expected to fall and repurchasing them at a lower cost.

Global Index ETFs –It gives investors exposure to both developed and emerging markets to optimise their portfolio.

In developed countries, the ETF market is primarily dominated by institutional investors, but in India, retail investors enjoy the larger market share. The primary distributors of ETFs are the banks, who find it easier to sell open-ended Mutual Funds like funds. If you want to sell or purchase ETFs, you need a DEMAT account, or you can buy from the banks.

ETFs vs Stocks

Stocks are a medium to show ownership interest in a company, whereas ETFs are a collection of investment vehicles that can be traded in the market like stocks.

Stocks give you more control over your investment, but ETFs give you greater market exposure. The commodities featured in ETFs are handpicked by professional experts.

Keeping the particular characteristics in mind, let’s now see which is a better choice for investing.

The decision to invest in ETFs is not different from any other investment decision, that is, to look for ways to reduce risk and generate a return that will beat the market. One way to minimise risk is to diversify a portfolio. ETFs help in that.  However, general investors believe that ETF generates only an average return compared to stocks. But this assumption isn’t correct. Return on any investment depends on the sector. If you select the right industry to invest, you will receive a greater return.

ETFs vs Mutual Funds

Mutual Funds (MFs) and ETFs are similar on many grounds, but there are a few dissimilarities, especially in the ways both are managed.  Here is a crucial difference,

ETFs are traded in the market like stocks throughout the day, but MFs can be purchased at the end of the day based on calculated NAV value. MFs are also actively managed by portfolio managers; on the other hand, ETFs are indirectly managed based on a particular market index.

Besides, ETFs funds charge lower annual fees as compared to traditional mutual funds investment.

ETFs vs Index Funds

ETF funds are a lot like Index Funds. But there are subtle differences; most significantly in the way both are traded. You can exchange ETF funds anytime during trading hours, but Index Funds are purchased or sold only at the beginning or end of a trading day.

ETFs are also more tax-efficient than index funds. When you sell ETF funds to another buyer, the money comes directly to your account. But in case of Index funds, you need to redeem it, which means capital tax is levied on it.

Are ETFs good investment?

It is a good choice since it allows investors to diversify their portfolios immediately.  Moreover, it is cheaper than Mutual Funds and Index Funds and has high liquidity like stocks. Some experts also believe that ETFs make an excellent option for young and new investors, who want to invest in the market without the headache of monitoring trends every time.  But there are a few things to keep in mind while considering it as an investment option.

  • ETF funds will cost you more than stocks. If you are planning to invest, ask about all the fees in advance
  • ETFs offer your diversification, but it doesn’t hedge from volatility
  • Leveraged ETFs experience value decay over time even when an underlying asset shows an uptrend
  • ETFs offer you less control over taxable income
  • With ETFs, you have less control over choices of assets
  • There can be a difference between the price of ETF and the values of underlying assets
  • Often ETFs are linked to benchmark indexes which means they aren’t allowed to outperform indexes

When Investing In ETFs Make More Sense Than Picking Stocks?

Stocks give you more control over your investment and higher return than other asset classes. But in some situations, opting for ETF investment is a sensible thing to do, like in the following cases,

  • Sectors that have marginal dispersion in return; all the companies from the industry generate similar returns. It gives no advantage to the stock pickers to select one company stock over the others
  • When stocks from a sector offer disperse return, but investors aren’t able to identify the cause behind the erratic drive

ETFs are professionally managed pool funds. It gives you the advantage to invest in a sector as a portfolio. So, when stock picking becomes difficult, investing in ETF makes more sense.

The Bottom Line

ETF offers the best of both worlds. It offers liquidity like stocks, minus the high-risk element. It allows you to diversify like mutual funds, but not binding like it. Lately, ETF funds are enjoying great popularity as an investment vehicle, as investors are looking for new options.

ETFs are preferred for long-term investment. So, if you make an informed choice, there shouldn’t be any reason for you to worry.