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.
- 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.
- 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.
- 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.
- 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. Depending on the choice of underlying asset class, ETFs can be of many types such as Commodity ETFs, Sector ETFs (could be based on the Global Industry Classification Standard GICS), Bond ETFs, Currency ETFs, Global Index ETFs or Inverse ETFs.
What are Index ETFs?
Index ETFs are exchange-traded funds, track and replicate the returns of a benchmark index. These are pretty like index mutual funds, but whereas investors redeem mutual fund units at one price each day (calculated NAV value), ETFs are transacted throughout the day like ordinary stocks.
An ETF follows the stocks in the index and offers instant portfolio diversification like mutual funds. These funds may trade at a premium or discount against computed NAV, depending on the changes in underlier price. But these differences exist only for a short time and get rubbed out through arbitraging by institutional investors.
The price of ETFs moves with the intraday price of its underlying stocks. But there is another type of ETF called leveraged ETF or short ETF. It is like regular ETFs with a leveraged multiplier, which performs better when the underlying asset price falls.
Usually, the cost of investing in index ETFs is lower than investing in mutual funds. It is comparable to the cheapest no-load index mutual funds. However, investors will have to pay a standard commission for buying and selling units. But you can also select from the wide range of non-commission ETFs to avoid paying commissions on transactions. ETFs offer lower expense and brokerage commissions than trading stocks individually.
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:
Advantages of ETF:
- 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.
- 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.
- Advanced trading mechanisms such as buying on margin, creating limit or stop orders are possible.
- ETFs allow minimal investments which means even beginner investors or those with small savings can also invest.
- 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.
Cons of investing in an ETF:
- 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.
- It can be difficult to sell off an ETF if it isn’t traded frequently.
- 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.