ETFs 101- What are Exchange Traded Funds (ETFs)? A Beginner’s Guide to Investment
Exchange Traded Funds (ETF) is an investment fund traded on stock exchanges, similar to individual stocks. Trading ETFs have become increasingly popular among investors due to their low fees, diversification, and transparency. ETFs can offer an easy way for ETF investors to access a diversified portfolio of stocks, bonds, or commodities, without the hassle of managing individual assets.
Thus, this blog aims to provide a comprehensive guide for beginners to understand what are ETF funds, type of ETFs, and their benefits. We will discuss what ETFs are, their evolution over time, the benefits they offer, how to invest in them, and factors to consider before investing.
What are ETFs in the Stock Market?
An ETF is a tradable instrument that tracks an index like Nifty/Sensex, a commodity like gold, bonds, or a basket of assets. The first ETF in India was created in 2001 when Benchmark Mutual Fund launched the Nifty ETF Fund with a defined objective to track the performance of the Nifty 50 index. Since then, the ETF industry in India has witnessed slow but steady growth.
Exchange Traded Funds are quite similar to mutual funds. The main difference being the former is listed on exchanges & trades just like stocks. ETFs can be typically more tax-efficient than mutual funds, as they have lower capital gains distributions.
Another key difference between ETFs and individual stocks is that ETFs expose investors to a diversified portfolio of assets. When you invest in an ETF, you are buying a small piece of a larger portfolio of stocks, bonds, or commodities, which helps to minimize your investment risk.
How ETFs Work?
Exchange Traded funds are a type of mutual fund that tracks and follows a specific index or asset. This could be an index like Nifty 50 or an asset like Gold ETF. The ETF will closely match the constituents of an index or the price of an asset.
An ETF trades on stock exchanges and can be bought and sold during market hours, the same way we would buy and sell stocks of listed companies. As mentioned above, an ETF tracks an index. So, if you invest in a Nifty ETF, you will generate the exact same returns as the Nifty. If Nifty goes up by 10% in a year, your Nifty ETF will also give you 10% returns for the same period. Because ETFs may not require any active portfolio management, they are low-cost instruments.
What are the Different ETF Types?
There are different types of ETFs to invest in:
- Index ETFs: Most common type of ETF, and they track a specific index such as the S&P 500 or the Nasdaq. These ETFs offer exposure to a broad range of stocks and are a good option for investors seeking diversification.
- Sector ETFs: Focus on specific sectors of the economy, such as IT, healthcare, or energy. If you believe a particular sector is poised for growth, these ETFs can be a good option.
- Bond ETFs: Tracks a basket of bonds, such as Treasury bonds or corporate bonds. These ETFs can be a good option for investors seeking income and capital preservation.
- Commodity ETFs: Tracks commodity ETF prices of commodities such as gold, silver, or oil. These ETFs can be a good option if you want to invest in commodities but don’t want to buy physical commodities.
- Small Cap ETFs: A type of ETF that invests in companies with smaller market capitalizations. These companies are often younger and have a higher growth potential than larger, more established companies. Small-cap ETFs can be a good way for portfolio diversification and capture the potential for high returns.
Some of the most popular ETFs include SPDR S&P 500 ETF Trust (SPY), Invesco QQQ Trust (QQQ), and iShares MSCI EAFE ETF (EFA).
How to Invest in ETF in India?
To understand how to buy ETF in India, follow these simple steps.
- Before you invest in ETFs, it’s important to determine your investment goals and risk tolerance.
- Once you’ve determined your investment goals and risk tolerance, it’s time to select the right ETFs for your portfolio. There are many different types of ETFs, including index ETFs, sector ETFs, bond ETFs, and commodity ETFs.
- Select a brokerage platform to invest in ETFs. You’ll need to open an account with the brokerage platform and fund your account with cash or securities.
- You can now buy ETFs through your brokerage account by entering the ticker symbol and the number of ETF shares you want to purchase.
- Investing in ETFs is a long-term strategy. It’s essential to monitor your investments regularly and rebalance your portfolio if necessary. Rebalancing involves buying or selling assets to maintain your desired asset allocation.
How to Sell an ETF in India?
Now that we know the process of buying ETF, let’s have a look at how one can sell exchange traded funds in India.
- Ready Your Demat: Ensure your ETF units are in your Demat account linked to your preferred trading platform.
- Place the Sell Order: Login, search for the ETF, choose “Sell”, and enter quantity, order type (Market/Limit), and validity.
- Review & Confirm: Double-check details before confirming the sell order.
- Settlement & Proceeds: ETF units are debited from your Demat, and sale proceeds can be credited to your bank account within T+2 days.
- Taxes: Remember capital gains tax applies based on the holding period (short-term: 15%, long-term: 0%)
Why Invest in ETFs?
Choosing an ETF might be a more favourable option due to several critical factors influencing the future performance of mutual fund schemes, such as the track record of the fund manager, AMC, and long-term performance.
Therefore, ETFs can eliminate or reduce the influence of underperformers in their portfolios. Thus, in addressing risk, mutual funds face both systematic and unsystematic risks. Systematic risk is inherent in the volatility of equities, affecting both ETFs and actively managed funds. Unsystematic risk pertains to company or sector-specific risks that can be mitigated by mutual funds through diversification. However, residual unsystematic risks may exist in actively managed funds.
As always, investors must do their own research and/or consult their financial advisor before investing.
Uses of ETFs
ETFs can offer valuable advantages for investors seeking targeted exposure to specific industries, asset classes, regions, or currencies at a cost-effective rate. These investors can benefit from focused exposure without the need for in-depth research into specific industries. Moreover, the low operational expenses associated with ETFs make them suitable for long-term holdings, particularly for ‘buy and hold’ investors.
Furthermore, ETFs can be beneficial for those adopting an asset allocation approach to investing. Investors can identify ETFs that concentrate on specific asset classes with a minimal correlation coefficient to the rest of their portfolio. This approach helps mitigate portfolio volatility by ensuring that if one part of the portfolio experiences a certain movement, the selected ETFs exhibit a different trajectory.
Advantages of Investing in ETFs
It can be expensive for an investor to buy all the stocks of an index or impossible for him to buy a certain quantity of a commodity for a low amount, say ₹1,000. Therefore, an ETF solves this problem by giving the investor access to many stocks across various industries or allowing the investor to invest in a small quantity of the commodity at a reasonable price.
ETFs usually tend to have low expense ratios since they track an underlying index or commodity.
Below are a few advantages of investing in ETFs:
- Low Cost: Because actively managed mutual funds require the expertise of a fund manager and research team, these funds come with high management fees. ETFs, on the other hand, have little to no management fees.
- Real-Time Investments: ETF trading on an exchange, which is why they can be bought and redeemed at their real-time per unit price. The flexibility to invest or redeem during the day allows the investor to take advantage of sudden movements in the markets.
- Returns: Actively managed funds have the mandate to beat their benchmark index. This also puts them at risk of losing money instead of earning higher returns. An ETF tracks an index, which is why its performance will be in line with the index. If you believe that the Nifty is going to rise in the coming years, you can simply invest in a Nifty ETF and participate in its growth.
Disadvantages of Investing in an ETF
And while there are significant advantages of this instrument, let’s talk about a few disadvantages of ETFs:
- Tracking Error: ETFs that track an index suffer from something called tracking error. It is the difference between the index return and the fund return. Please note that this can also apply to any passive mutual fund which is tracking an index
- Poor Liquidity: In rare times of poor liquidity, the bid/ask spread (i.e. the buying/selling costs) can be high, leading to higher costs.
- Settlement Dates: ETF sales take two days to settle after the transaction, meaning that as a seller, your money from an ETF sale can be theoretically inaccessible for reinvestment during these two days.
- Limited Offerings: Lastly, there aren’t many varieties of ETFs in India yet – current offerings are limited to large & midcap index trackers, gold, and debt.
Difference Between ETF and Stocks
Let’s have a look at the differences between Exchange Traded Funds (ETFs) and individual stocks and what unique features set these two investment options apart.
ETFs vs Stocks
| Feature | ETF | Stocks |
|---|---|---|
| Ownership | Represents ownership in a single company | Represents ownership in a basket of various securities |
| Diversification | Provides instant diversification across multiple companies or assets | Exposes you to the fortunes (or misfortunes) of one specific company |
| Trading | Generally more flexible trading options like short selling and options | Typically limited trading options |
| Fees | Generally lower management fees | Fees can vary depending on the individual stock |
| Volatility | Tends to be less volatile due to averaging across multiple assets | Can be more volatile depending on the performance of the underlying company |
| Control | No control over individual holdings within the ETF | Offers the ability to influence the company through shareholder voting |
Investment Strategies
Once you’ve determined your investment goals, ETFs can be used to gain exposure to any global market or industry sector. Utilizing stock index and bond ETFs traditionally may allow you to invest your assets, and adjust the allocation based on your risk tolerance and objectives. Thus, incorporating alternative assets like gold, commodities, or emerging stock markets. Whether you aim for a conventional approach or wish to swiftly navigate markets to capture short-term swings akin to a hedge fund, ETFs can provide flexibility to every investor.
Tips for Selecting the Suitable ETF
Here are some tips for selecting the right ETF as per your investment goals
- Determine your asset allocation based on your risk tolerance and investment goals.
- Look for low-expense ratios to minimize your costs.
- Choose ETFs with high liquidity and narrow bid-ask spreads.
- Check the ETF’s holdings to ensure they align with your investment goals and risk tolerance.
- Evaluate the ETF’s performance over time.
Investing in ETFs via smallcase
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To invest in ETFs via smallcase, first login on the website or the app with your phone number. Then, go to ‘Discover’ and in the search bar, type ‘ETF’. You’ll now see an array of ETF smallcases based on various themes. You can pick the one that fits your investment criteria and invest in it. And…you’re done!
Things to Consider Before Investing in ETF
There are several factors that you should consider before investing in exchange traded funds. Let’s have a look at the significant ones.
- Underlying Index Selection: Ensure the ETF’s chosen index aligns with your investment objectives and desired asset exposure.
- Expense Ratios: Evaluate the annual costs (expense ratios) associated with managing the ETF; lower ratios can be preferable for better returns.
- Liquidity and Trading Volume: Consider the ETF’s liquidity and trading volume to ensure ease of buying or selling shares without significant price impact.
- Tracking Error: Investigate the tracking error, aiming for a lower value to ensure the ETF closely mirrors the performance of its underlying index.
- Diversification and Holdings: Examine the ETF’s holdings for diversification alignment and risk management in line with your investment goals.
To Wrap It Up…
ETFs have taken over the world, with AUM in such funds surpassing those in traditional mutual funds in many countries. The low-cost & instant liquidity provided by ETFs has potentially appealed to investors globally.
So, if you are a long-term investor with SIPs every month & no intention of redeeming in the near future, then ETFs can be a suitable option.
As always, investors must do their own research and/or consult their financial advisor before investing.
FAQs
Because ETFs trade like stocks, you can short-sell and trade them on margin. Additionally, most ETFs offer the advantage of lower expense ratios compared to the average mutual fund. One ETF example could be Invesco QQQ Trust (QQQ). It tracks the Nasdaq-100 Index, focusing on large-cap technology stocks.
An ETF investment isn’t a single stock, but a basket of stocks, bonds, or other assets traded like a stock, offering instant diversification and flexibility.
ETFs do not pay dividends. The dividends earned from the stocks held within the fund portfolio must be distributed by ETFs. Consequently, ETFs issue dividends in cases where any of the underlying stocks in which they are invested also pay dividends.
For most individual investors, investment in ETFs can be a good option since they are low-risk options that also give stock market exposure. However, one must consider their risk appetite and investment goals before investing.
Exchange Traded Funds and trade like stocks on exchanges throughout the day, offering flexibility but potentially higher costs. Whereas, index funds are bought/sold at the end of each trading day, offering lower costs but limited trading times.
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