Exchange-traded funds (ETFs) have gained immense popularity in the recent past, due to their versatility, liquidity, and potential for diversification. However, navigating the ETFs requires a solid understanding of key terms and concepts.
In this article, we’ll provide a comprehensive overview of essential terms and phrases associated with ETFs, offering investors a roadmap to make informed decisions in this dynamic investment space. But first, let’s understand more about ETFs.
What is an Exchange Traded Fund (ETF)?
An Exchange-Traded Fund (ETF) is a tradable financial instrument designed to track the performance of an index, commodity, bonds, or a diversified collection of assets, similar to what an index fund does.
In straightforward terms, ETFs are investment funds designed to replicate the movements of specific indexes like the Nifty or BSE Sensex. When you purchase shares or units of an ETF, you’re essentially acquiring a piece of a portfolio that mimics the returns and yield of its corresponding index.
The fundamental distinction between ETFs and other types of index funds lies in their approach. ETFs do not attempt to outperform their designated index. However, index funds are not optimised in real-time, which causes higher tracking errors than ETFs. In essence, ETFs aim to represent the market rather than surpass it.
Also Read More About the Types of ETFs
How do ETFs Work?
What sets ETFs apart from conventional mutual funds is their trading mechanism. An ETF acts exactly like an ordinary stock on a stock exchange. In fact, the price/NAV of ETF fluctuates throughout the trading day, similar to any other stock, as it is actively bought and sold on the stock exchange.
The trading value of an ETF is directly linked to the net asset value of the underlying stocks that the ETF represents. ETFs typically offer enhanced daily liquidity and cost efficiency compared to traditional mutual fund schemes, rendering them an enticing choice for individual investors.
Terminologies of ETFs
- Active Investing: In the case of funds, active investing involves hands-on management by the fund manager to surpass the performance of a market index or benchmark. Managed funds, for instance, often employ active strategies where investors pay for the expertise of the manager in an attempt to outperform the market.
- Alpha: Alpha denotes the extent to which an investment outperforms a market index or benchmark, primarily associated with actively managed investments.
- Ask Price: The ask price represents the lowest price at which a seller is willing to sell a security.
- Asset Allocation: Asset allocation stands as a critical method for managing risk and reward within your overall investment portfolio. It involves diversifying your investments across various asset classes, such as stocks, bonds, property, and cash, to achieve different risk and return profiles based on your investment objectives.
- Beta: Beta represents an investment’s return concerning a market index. An investment with a beta of 1 moves in tandem with the market. Most Exchange-Traded Funds (ETFs) are designed to mimic market returns and thus have a beta close to 1.
- Bid Price: The bid price is the highest price a buyer is willing to pay to purchase a security.
- Bid-Ask Spread: The bid-ask spread is the difference between the bid and ask prices, indicating the cost of executing a trade.
- Discount/Premium to NAV: When an ETF’s price is lower than its underlying holdings’ total market value, it is trading at a discount; if higher, it’s at a premium. Significant premiums or discounts with ETFs are rare.
- Diversification: Diversification goes beyond asset allocation to achieve a balanced risk and return profile. It involves selecting specific stocks and bonds within each asset class to spread risk. A diversified portfolio can mitigate losses if one investment underperforms.
- High-Yield Bonds: High-yield bonds, often included in portfolios, offer the potential for higher income. These bonds are issued by companies with lower credit ratings, providing higher yields to compensate for increased risk.
- Index or Underlying Index: An index is a collection of securities representing an entire market or a subset of it. It serves as a benchmark for investors and fund managers to measure performance. Common examples include the BSE Sensex, NIFTY 50, BANK NIFTY etc.
- Limit Order: A limit order specifies the number of shares or units to buy or sell at a particular price or better.
- Liquidity: Liquidity measures how quickly an asset can be converted into cash without affecting its price. Higher liquidity assets are easier and cost-effective to trade, while low liquidity assets may entail higher trading costs and challenges in buying or selling.
- Managed Fund: A managed fund pools investors’ money and is professionally managed to buy and sell assets. These funds aim to outperform market indices, and they are also known as mutual funds in some regions.
- Minimum Volatility: Minimum volatility strategies aim to minimise the impact of market fluctuations on investments. They can help mitigate risks associated with factors like interest rate changes, currency shifts, or sudden stock price fluctuations while providing returns close to the market.
- Net Asset Value (NAV) per Unit: NAV per unit is the fund’s gross assets minus liabilities, divided by the number of outstanding units.
- Physical ETF: A physical ETF tracks an index by holding most or all of its underlying assets. For instance, an ETF following a stock market index will own the stocks in that index. Physical ETFs are generally considered lower risk compared to synthetic ETFs.
- Stop-Limit Sell Order: A stop-limit sell order triggers a limit order for an ETF when its unit price reaches a set level (the stop price), helping protect gains or minimise losses.
- Tracking Error: Tracking error measures a fund’s performance against its benchmark index, quantifying the historical difference between the two. It’s often expressed as the standard deviation of performance differences over time.
- Yield: Yield refers to the return on investment earned by an ETF. Yield is often expressed as a percentage of the initial investment amount. For example, if an ETF priced at ₹100 pays a ₹5 return, its yield is 5%.
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What is an ETF?
An ETF, or Exchange-Traded Fund, is like a collection of different investments that are traded on the stock exchanges. It aims to track the performance of an index, asset class, or commodity. ETFs are traded just like stocks, but ETFs have different underlying assets, unlike stocks of a particular company.
Are ETFs good for long-term investment in India?
ETFs can be suitable for long-term investment in India due to their diversification, low costs, and transparency. However, their suitability depends on your specific financial goals and risk tolerance.
Can I sell ETF shares anytime?
Yes, you can generally sell ETF shares anytime the stock market is open. ETFs are traded like stocks on stock exchanges, offering flexibility in trading.
Is it advisable to hold ETFs long-term?
Holding ETFs long-term can be a viable strategy, provided they align with your investment goals. Regularly review your portfolio to ensure it meets your objectives.
Disclaimer: This blog is exclusively for educational purposes. The securities quoted are exemplary and are not recommendatory.