In your quest to ensure a sizeable retirement fund for your future or have enough for your child’s college education, you may come across various investment options. One of the most common instruments you will come across is the Exchange-Traded Fund (ETF).
What is an ETF?
An Exchange-Traded Fund offers the investor a basket of different securities, ranging from the traditional stocks and bonds to more modern securities such as currencies and commodities. The objective of an ETF is to offer the investor the opportunity to invest in multiple assets in real-time at a low cost.
The investor can buy or sell their shares of an ETF through a broker. ETFs are traded on a stock exchange.
The workings of an ETF:
Now that you know the answer to ‘what is an ETF?‘, let’s see how an ETF works.
The fund provider who owns the underlying assets designs a fund to track the overall performance of the fund. They then sell shares of this ETF to investors. The investor holds a percentage of the ETF but doesn’t own the assets comprising the ETF.
The investors do get reinvestments or dividends from the stocks that are included in the ETF.
The number of shares of the ETF can change daily since it can issue new shares as well as redeem the existing shares. This helps keep the market price of the ETF more or less in line with that of the underlying securities.
Difference between an ETF and Mutual Fund:
A simple glance at the ETF meaning may make the investor think that it is a synonym for a Mutual Fund due to their similarities. However, both are quite different.
1. The most significant difference between an ETF and Mutual Fund is that the former can be traded throughout the trading day while the latter can be bought or sold only after the market closes for the day.
2. An ETF is typically managed passively by the manager as it usually tracks one market index. In contrast, a mutual fund is actively managed with an expert fund manager keeping an eye on when to buy or sell certain assets within it to make a profit.
3. An ETF has a relatively lower fee and expense ratio since it can be passively managed, unlike a mutual fund which needs to be actively managed and hence, comes with a higher fee.
4. In terms of taxes, an ETF investor has to pay taxes only when they sell their share(s) whereas, in a mutual fund, the investor has to pay a tax through the course of their holdings.
Now you know the main distinctions between an ETF and a Mutual Fund.
Types of ETFs:
There are various types of ETFs you can invest in depending on your needs.
A Bank ETF comprises stocks of banks that are listed in an index that the ETF follows. Such ETFs are quite volatile and have high liquidity. A Bank ETF is known for being easily tradable on margin.
A Liquid ETF trades only on national exchanges such as the BSE and NSE. It is known for its low-risk return as well as high liquidity. The basket of investments comprises of short-term government securities, call money, and instruments with short maturities.
For any investor looking to invest in internationally-based securities, whether it is a foreign company or currency, this type of ETF is a good option. An International EFT helps build an even more diverse portfolio since it can consist of hundreds of companies spread across the globe. The investor can choose this type of ETF based on geography, market capitalisation, sector, or any other parameter that they deem fit. If you are considering an International ETF, be sure to understand the attached fees, taxes, liquidity, trading volume, and details of the portfolio, before investing.
Here, the ETF comprises either one or more commodities, including agricultural goods, natural resources, or precious metals. The investor doesn’t own the physical commodity. Examples of Commodity ETF include the SPDR S&P Oil & Gas Exploration and Production ETF, and the iShares MSCI Global Agriculture Producers ETF.
A Gold ETF falls under ‘Commodity ETF’, but it is such a widely traded ETF, that it deserves its own space. This type of ETF is a good option for those who believe that gold is always a reliable investment but don’t want to buy too much physical gold. A gold ETF allows investing through Systematic Investment Plans (SIPs). The price of the ETF works in tandem with the price of physical gold; if the price of physical gold rises, so will the value of the ETF.
A Stock ETF constitutes of only stocks and no other securities. They are usually well-suited for an investor looking for a long-term investment. They are less risky and come with a lesser fee than individual stocks.
A Bond ETF comprises different bonds making a common maturity date impossible to have. The objective of a bond ETF is to provide the investor with regular cash payments generated from the interest on individual bonds. Bond ETFs complement a Stock ETF well and are less risky.
A sector-specific ETF means that the basket of securities will focus on only one industry, such as healthcare. This is a good idea for those who are sector experts and can safely predict the performance of the sector. However, a sector ETF can be risky as it offers limited diversification options.
While choosing a particular ETF, it is essential to have some working knowledge of the type of ETF you are investing in so that you can keep an eye on it.
Pros and Cons of an ETF:
Just like any other investment instrument, an ETF has its pros and cons.
Here are the advantages which will encourage an investor to consider putting their money into an ETF seriously:
1. ETFs offer some of the best diversification. You can not only invest in multiple companies at one-go, but also various industries or global markets.
2. You can trade in an ETF just like any other stock, through the market hours, ensuring that you can act swiftly based on market news, local and global events.
3. Advanced trading mechanisms such as buying on margin, creating limit or stop orders are possible.
4. ETFs allow minimal investments which means even beginner investors or those with small savings can also invest.
5. An ETF offers transparency. Your ETF will disclose its holdings at the end of each day, and you can gauge and reassure yourself of the value of the underlying assets for yourself.
Some of the cons of investing in an ETF include:
1. There could be a significant trading commission charged by the broker on your trades. This could eat into your profits. However, more and more brokers are letting go of this fee to keep up with the changing protocols.
2. It can be difficult to sell off an ETF if it isn’t traded frequently.
3. In case the ETF doesn’t have enough assets that can cover the administrative cost, it could close. This could lead to selling your shares before you intended to, and at a loss. There is also the risk of a tax obligation you didn’t expect at that time.
However, the benefits of an ETF far outweigh the cons associated with it. Make sure you do your research and seek the guidance of a professional before you invest.
ETFs in India:
India has come a long way since the ETF was first allowed in the country, way back in 2001. Today, there are tens of ETFs that track many major indexes in India and abroad such as NIFTY 50, Sensex, S&P 500, or the NASDAQ. India has a rapidly growing IT, finance, and healthcare sector which boosts the economy and opens the doors for profitable ETFs. Additionally, the emphasis on increasing digitisation, expanding middle-income groups, spurts in electronic payments platforms have all given an impetus to the economy. India is a promising country with many ETF options for the discerning investor.
ETFs are known for their innovation. If you believe that an ETF is the best form of investment, then conduct your due diligence to find out which ETFs are best suited to help you meet your financial goals. Once you’re confident enough of your choices, ask your broker to make the transaction for you.