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Exchange-Traded Funds provide investors with the option to invest in a diversified basket of assets. Several types of ETFs are available in the securities market, with intraday trading and real-time execution.
Investors who want to diversify their holdings without taking on a huge amount of risk may find ETFs a good option.
This article explores ETFs, types, advantages, disadvantages, and how to invest in ETFs.
Key Takeaways
- Most ETFs passively follow an index and trade on exchanges.
- ETFs are a low-cost cross between stocks and mutual funds that diversify an investor’s holdings. These funds can be traded throughout the day and offer real-time execution, with settlement happening on a T+1 basis.
- You can invest in ETFs via two methods: a one-time order and Systematic Investment Plans.
- When evaluating an ETF, investors must focus on the amount of risk they are willing to undertake and their financial goals.
Types of ETF Exchange-Traded Funds
With the growth of ETFs, investors now have several options to diversify their portfolios. Here are the basic types:
Equity ETF
Equity ETFs, also called stock ETFs, follow an index of stocks, such as the Nifty 50 index. Market capitalisation, investment style, strategy, and regional exposure are the basis for categorising various equity ETF types.
Operational Checkpoint: Investors should monitor tracking difference, tracking error, and intraday bid-ask spreads to ensure the fund closely replicates its target index without performance drag.
Fixed-Income ETF
These exchange-traded funds invest in fixed-income securities such as corporate bonds or treasuries.
Operational Checkpoint: Key factors include Yield to Maturity (YTM), portfolio duration (sensitivity to interest rate shifts), and average credit quality to gauge default and interest-rate risks.
Commodity ETF
A commodity ETF tracks the price movements of commodities like gold or oil. A commodity stock ETF invests in the stocks of commodity producers.
Operational Checkpoint: Investors should look at tracking difference, underlying asset purity/custody, and storage cost impacts reflected in the expense ratio.
Currency ETF
To track the relative value of a currency or a basket of currencies, currency ETFs can be used. These give retail investors exposure to the forex market through a professionally managed fund without having to trade independently.
Operational Checkpoint: Pay attention to expense ratios, roll-over costs (if futures-backed), and the tracking discrepancy against spot currency exchange rates.
Real Estate Investment Trust (REIT) ETF
These funds invest a large portion of their assets in REIT stocks and related derivatives. The ETFs are passively managed, meaning the fund manager invests in REIT-index constituent stocks.
Operational Checkpoint: Review underlying dividend yields (distribution yields), portfolio concentration limits, and leverage levels carried by the constituent REITs.
Multi-asset ETFs
Exchange-traded funds that invest in multiple asset classes, such as a combination of stocks and bonds, are known as multi-asset ETFs. These are often designed to generate a diversified portfolio inside a single investment.
Operational Checkpoint: Check the fund's rebalancing frequency, asset allocation drift limits, and the weighted average expense ratio across underlying segments.
Alternatives ETFs
These employ alternative investment methods like private equity or hedging and often don't fit into the traditional ETF categories. These special funds typically give investors access to market segments they might not otherwise have.
Operational Checkpoint: Evaluate strategy complexity, liquidity of underlying holdings, and potential counterparty or derivative risks.
Sustainable ETFs
Sustainable ETFs, also referred to as ESG ETFs, are exchange-traded funds that frequently follow the performance of an index of stocks or bonds issued by businesses that meet specific environmental, social, and governance standards.
Operational Checkpoint: Scrutinize the provider's ESG screening methodology, sector exclusion criteria, and whether the index substitution rules create tracking divergence from broader parent benchmarks.
How to Invest in ETFs?
- Open the broker’s app or website.
- Select ETF on the home page.
- Choose an ETF to invest in.
- Select a one-time order or Systematic Investment Plan (SIP).
- Place the order.
ETFs vs Mutual Funds
| Feature | ETFs | Mutual Funds |
| Demat account needed | Yes | No |
| Pricing | Real-time market price | End of the day pricing (net asset value) |
| How to buy | Sold and bought on stock exchanges during market hours | Purchased and redeemed through Asset Management Companies or their distributors |
| SIP Available | Yes | Yes |
Advantages and Risks of ETFs
Advantages of ETFs
Diversification: One can put money in an entire index or sector through a single unit.
Lower Costs: As ETFs are passively managed, expense ratios are usually lower than active funds.
Transparency: The holdings that make up an ETF are disclosed daily.
Liquidity: ETFs can be converted to cash quickly, with transactions taking place during market hours.
Risks of ETFs
Volatility: The value of the investments can fluctuate throughout the day.
Liquidity risk: A higher bid-ask spread may be present due to low trading volumes.
Tracking error: Differences can be present between the ETF value and the index it tracks.
Conclusion
ETFs, or exchange-traded funds, are investment options that hold a basket of securities such as bonds, equities, or commodities. Several types of ETFs exist, from currency and commodity exchange-traded funds to multi-asset ones. One must choose the best ETF for investment based on their financial goals and risk appetite.
