What is Exchange Traded Funds (ETF)

ETF (Exchange Traded Fund) is a stock market investment that tracks indexes like CNX Nifty or BSE Sensex, as well as commodities, bonds, or a mix of assets.
What is Exchange Traded Funds (ETF)
3 mins read
17 June 2024

An Exchange Traded Fund (ETF) is a collection of marketable securities that track an underlying index. An ETF is a collection of securities such as stocks, bonds, commodities, or a basket of assets like an index fund. It combines the features of different investment options, such as mutual funds and stocks. While it is like index funds, there is a point of difference. ETFs can be bought or sold on stock exchanges like stocks.

More important details are provided in the following sections.

Types of ETFs

Discussed below are the various types of Exchange Traded Funds:

1. Equity ETF

Equity ETFs are described as passive investment options combining the features of stocks and equity mutual funds. Investors can trade these funds on stock exchanges, namely the NSE (National Stock Exchange) or BSE (Bombay Stock Exchange). They can purchase or sell these funds at market prices on a real-time basis.
While the minimum investment quantum is one unit, there is no specification regarding the minimum investment amount. Equity ETFs are cost-effective and provide transparency regarding their holdings.

2. Bond ETF

Through bond ETFs, investors receive exposure to various fixed-income instruments such as Government bonds (with different maturities) and debentures. These ETFs combine the features of stock investments with the benefit of debt investments and the simplicity of mutual funds. People can trade bond ETFs on the open cash market.

3. Commodity ETF

Gold and silver ETFs are the only commodity ETFs available in India right now. These are passively managed funds tracking an underlying market index. The NAV (Net Asset Value) of commodity ETFs is subject to change throughout the day. The movement in prices depends on the demand and supply of the commodity in the markets.

4. Sectoral/ thematic ETF

A sectoral or thematic ETF tracks the performance of a particular sector or theme. A sectoral Exchange Traded Fund invests in a specific industry, such as banking, pharmaceuticals, and real estate. A thematic ETF focuses on an idea that encompasses multiple sectors like consumption or ESG (Environmental, Social, and Governance).

5. International ETFs

International Exchange Traded Funds replicate the index of a foreign country or that of the global market. These ETFs provide the opportunity to invest directly in foreign companies. They are similar to international mutual funds. Investors could use such ETFs to diversify the political and geographical risks associated with their portfolios. The price determination depends on the region-specific timelines and takes place at the end of the day.

How do Exchange Traded Funds work?

ETFs function like a basket of investments traded on a stock exchange. The provider creates the ETF by pooling underlying assets like stocks or bonds, then offers shares in this basket to investors. While investors own a portion of the ETF, they don't directly own the underlying assets. ETFs that track a stock index can distribute dividends to shareholders, similar to how the companies within the index pay dividends.

How to buy and sell ETFs?

Given below are steps to purchase units of an ETF:

Step 1: Open a Demat and trading account with an online brokerage firm. Before that, conduct thorough research and decide on the fund to invest in.

Step 2: A variety of options will be available depending on the AMC (Asset Management Company). Insert the correct symbol and number of shares to purchase.

Step 3: Depending on the preferred ETF transaction, place an order and click on ‘submit’. After the completion of the deal, the investor will receive an order update.

Investors can sell ETFs throughout the day. It enables them to benefit from intraday price changes. This is in stark contrast to mutual funds, where investors can make a purchase or redemption only at the end of a trading day.

Risks of ETFs

Let us explore some risks involved with ETFs:

  • Transaction costs: Frequent small investments might be cheaper through a no-load mutual fund directly with the fund company.
  • Lower liquidity: Unpopular ETFs may have wider bid-ask spreads, meaning you pay more to buy and receive less when you sell.
  • Tracking imperfections: While ETFs aim to match their index, technical issues can cause slight deviations in performance.
  • Settlement delays: Selling ETFs takes two days to settle, meaning the money is not immediately available for reinvestment.

Advantages and disadvantages of ETFs

The benefits and limitations of investing in ETFs are given in this section:

Advantages

The benefits of investing in ETFs are as follows:

  • It is quite easy to understand the investment returns of Exchange Traded Funds.
  • Investing in ETFs helps to mitigate unsystematic risks due to its passive investment strategy. It also lowers one’s overall investment risk.
  • It greatly helps with portfolio diversification.
  • With the limited role of fund managers, ETF investments are comparatively cost-effective.

Disadvantages

Listed below are the disadvantages of investing in ETFs:

  • Some people consider ETFs to be a non-efficient investment option. This is primarily because the investment returns mirror the underlying index.
  • Fund managers of ETFs are unable to choose portfolio securities or deviate from the index weightage. So, investors shouldn’t expect the ETFs to outperform their underlying indices.
  • Moreover, ETF trading depends a lot on the liquidity of the units.

Conclusion

Exchange Traded Funds are a useful investment option for investors who wish for exposure to a particular asset class, industry, region, or currency. People don’t have to worry much about conducting thorough research on specific sectors or industries. Furthermore, due to low operational expenses, these assets are well-suited for long-term investments.

While the popularity of ETFs is growing rapidly, it would be wise if investors evaluated which funds would be best suited for them after formulating their investment goals and assessing their risk appetite.

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Frequently asked questions

What is the exchange traded fund?

ETFs (Exchange-Traded Funds) are funds traded on stock exchanges that track a specific index. Investing in an ETF lets you buy and sell a bundle of assets during market hours, helping to lower risk and diversify your portfolio.

Is ETF better than mutual fund?

The choice between ETFs and mutual funds depends on individual investment goals and preferences. ETFs offer advantages like intraday trading, while mutual funds may provide more diversified portfolios managed by professionals.

Is ETF tax free?

ETFs are subject to taxation on capital gains, dividends, and other income, similar to mutual funds. However, specific tax implications may vary based on factors like holding period and the investor's tax status.

Can I sell ETFs anytime?

ETFs can typically be sold anytime during market hours, offering liquidity and flexibility to investors.

How do I buy an ETF?

Investors can buy ETFs through a brokerage account, similar to purchasing stocks. They can place buy orders through online trading platforms or directly with their brokers.Top of Form

What is an ETF example?

An example of an ETF in India is Nifty BeES (Exchange Traded Fund). It tracks the Nifty 50 index, which means it holds the same 50 large Indian companies as the Nifty. By investing in Nifty BeES, you get exposure to these leading companies and the Indian stock market's performance.

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