What is ETF? Beginners Guide to ETF Investment

Podcast Duration: 06:20

If you are exploring the stock market, you have most likely chances upon the term ETFs. So what are ETFs? ETFs, or exchange traded funds are baskets of securities that track an underlying index such as BSE Sensex or CNX Nifty. Like a mutual fund its performance depends on the securities under its umbrella; however unlike a mutual fund (that is traded once a day), an ETF is traded throughout the day like any other stock. Its price fluctuates consistently throughout the day. It is different from a stock however, because it contains various assets instead of just one. In fact, ETFs can hold hundreds of underlying assets.

Here's a simple analogy to give you an idea of what ETFs are: You can compare an ETF to a Diwali hamper. The various components of the Diwali hamper are up for sale individually.. you can buy mithai, cookies, dried fruits, namkeen, the basket itself and the packaging individually. Alternatively one can buy the basket-slash-hamper. An ETF is the equivalent of the hamper. The underlying securities themselves are traded on the stock exchange. Alternatively one ca opt to buy the basket, in this case the ETF. Now just like the price of the hamper will depend on the price of the individual components, so the price of the ETF is governed by the performance of the underlying assets. If the underlying assets perform well, then the ETF performs well.

There are several types of ETFs traded in India. These are

Index ETFs

Gold ETFs

Sector ETFs

Bond ETFs

Currency ETFs

Global Index ETFs

ETFs are especially favored for by investors seeking diversification. This is because:

ETFs may span several different sectors or may be restricted to one specific sector. ETFs include equity (that is shares) and also bonds and commodities. Given that the investors capital is being spread over a wide variety of sectors and investment categories, ETFs are often seen as a relatively low risk investment option.

Besides diversification and correspondingly less risk, which is the most obvious benefit of ETFs, this type of stock market investment is also low-cost. The expense ratio for ETFs is usually a fair bit lower than that of equity funds.

This is because there is no need for active management by a fund manager. And that friends, brings us to the next plus point of investing in ETFs. And that is less margin for human error because there is no fund manager involved.

In fact, there is a theory called the Efficient Market Hypothesis that goes to say that it is impossible for any fund manager to consistently outperform the market. Apparently it is impossible to do so because share prices reflect all information. If that is indeed the case then it makes good sense to invest across the market, doesn't it?

ETFs, like stocks, are highly liquid. In case of an urgent capital requirement, ETFs can be promptly sold during the trading day. Of course whether it will be a good time to sell or not is an entirely different matter, but you get the point - ETFs are highly liquid. You don't have to wait till maturity to retrieve your capital.

I bet you're ready to ask how to invest in ETFs given these positives but here are a couple of considerations before you invest:

ETFs take away the trader's ability to outperform the market. So traders with tremendous experience and great prediction talent might find earnings to be too slow.

Now let's talk about how to invest in ETFs and how to buy ETFs:

You need to buy ETFs on the stock market. Arm yourself with a Broking app and a demat account to start investing in ETFs. You can download a Broking app free and set up your demat account in a few hours today. The process is completely virtual and hassle-free.

Now that you are geared with information on what ETFs are and how to buy ETFs, you have almost covered ETFs 101. But before we wrap up, let's have a quick look at how to choose ETFs:

Requirement number 1 - liquidity:

When choosing an ETF look for one that offers high liquidity because this will determine potential profitability.

Requirement number 2 on how to choose ETFs - low expense ratio

Be sure to check the expense ratio which includes the management fee, distribution fee and whatever else is cut from the investors returns.

Requirement number 3 on how to choose ETFs - minimal tracking error Tracking error can be identified by comparing how much the fund's NAV to the index's actual return.

If an ETF fails to meet these three requirements it sows not offer the very features that make ETFs beneficial and popular in the first place.

On the subject of how to invest in ETFs, one has to highlight this: Cautiously! That's right ETFs must be invested in with a reasonable amount of caution, like all other stock market investments. It is true that diversification makes ETFs low-risk but like all stock market investments, it is not possible to completely eliminate the risk of potential losses. Thorough research is a must prior to investment in ETFs. Moreover since returns are not guaranteed, it is advisable to invest capital that is surplus after taking care of one's basic living and lifestyle expenses. Invest enthusiastically, but also carefully always.