Exchange Traded Funds (ETF) are passively managed funds that give returns equivalent to underlying index at low cost. Passively managed means it does not require an active involvement of fund managers. In exchange-traded funds, fund manager does not select stocks, it simply copies stock of underlying index for mimicking returns equivalent to index.
There are multiple types of traded funds such as index fund, bank fund, money market fund, gold fund etc. The investor can invest in ETF based on the risk profile. Let’s look at How ETF works, Types of ETF and Benefits associated with ETF.
How Exchange Traded Funds Work?
Exchange Traded Funds invest in limited company stock, gold, bonds or commodity based on the underlying index of tracking. ETF divides total assets into a number of parts and sells it as a unit.
E.g Gold ETF single unit is equivalent to 1gm of gold. It is backed by 1gm physical gold. The current trading value of a Gold ETF is based on the gold market price. The change in gold price causes a corresponding change in the price of ETF.
ETFs are traded on the stock exchanges like a stock of companies. This means the price of ETF changes throughout the day whenever ETF are bought or sold.
Benefits of ETF Investments
Key Benefits offered by ETF investment is given below.
- ETFs are cost-efficient. As ETF does not carry active portfolio churning you will get the benefit of low expense ratio in ETF. ETF is cheaper compared to other mutual funds.
- Exchange traded fund allows investors to avoid the risk of poor stock selection by a fund manager. A stock or underlying asset is selected based on index fund follows.
- Diversification is another key benefit that an investor gets from Exchange Traded Fund investments. One can potentially choose from a wide range of ETFs which mainly differ based on the underlying asset.
- ETF offers anytime liquidity via exchanges. You can sell ETF during exchange operating timings.
- ETF also offers intraday trading facility. This means you can earn money by doing Intraday trading in exchange traded funds.
Drawbacks of Exchange Traded Funds
- ETF are not sold directly. You need to pay trading commission to brokerage house every time you bought or sold traded funds.
- Many time ETF suffers from tracking error. Drawback is you will not get performance of the index which this fund is following.
- Trading volumes are low in few ETFs. You have to be careful in dealing with such traded funds.
Types of ETF in India
There are multiple types of exchange traded funds available in India.
Index Fund is one of the oldest etf category. Index fund invests in stocks in amounts that proportionately reflects the stocks of existing index in the given market. Investor who want to replicate return of index can invest in these funds.
Bank Fund invest in the stocks of banks listed on the index that it follows. Bank ETF are highly volatile and risky in nature.
Gold ETF invest in gold and track the market price of gold. Gold ETF also allows investment via SIP route. If you are planning to invest in gold, it is recommended to look at Gold ETF.
Liquid ETF invests in money market, short term government securities and money market instruments. These type of ETF are safe in nature.
International ETF invests in foreign based securities. If you want to enhance your foot print and invest in global market you can invest in international ETF.
ETF vs Mutual Funds
|Passive Management||Active Management|
|Lower Cost of Investing||Higher Cost of Investing|
|Tradability – More Liquid||Tradability – Less Liquid|
Who should invest in Exchange Traded Funds?
Exchange Traded Funds are for new investors. If you are first time investor and not acquainted with stock market, you can plan to invest in ETF which are passive in nature. ETF provide access to the equity market with limited risk.
If you are risk adverse investor and your financial goals are matching with traded fund you can invest in these funds. Make sure to select appropriate broker with lower fees when you buy these funds.