According to AMFI, "An ETF, or exchange-traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund."
Exchange-traded funds are a more liquid form of mutual funds. While mutual funds, much like ETFs, are a portfolio of securities, they aren't traded on exchanges like ETFs. The redemption process for mutual fund holdings takes a couple of days, while ETFs are actively traded on exchanges and can be redeemed in real time.
So, are ETFs worth investing in? Yes, they are worth investing in if you want a liquid, long-term investment with lower fees. However, investors should be careful of the common pitfalls to potentially benefit from ETFs. This ETF investing 101 guide walks you through the mistakes to avoid.
Understanding ETFs
An ETF is a security that is a collection of other securities, like a bundle (a unit of ETF) and is traded on an exchange. There are various types of ETFs based on the securities they hold. For example, some ETFs track a specific index, such as the NIFTY50, while some focus on specific sectors, like information technology or energy.
ETFs can be passively or actively managed. Passive ETFs replicate the indices, and the fund manager doesn't have to make major adjustments to the portfolio. Conversely, actively managed ETFs aim to outperform the market through active portfolio management. However, in India, ETFs track an underlying index.
Their operations are straightforward and offer many advantages like liquidity and lower volatility. Just like mutual funds, ETFs also offer transparency by clearly stating the assets they hold and publishing their net asset value (NAV) every day. The assets may contain stocks, bonds, or other securities.
Even after all these benefits, one should understand how ETFs work and assess their suitability for an individual's investment requirements and strategy.
Investors should be informed and vigilant because any wrong step can lead them to financial losses.
Common Mistakes to Avoid
1. Investment Strategy
Failure to analyse the investment strategy and an ETF's composition is a common mistake. Understanding the primary assets and checking if they align with the investment objective and risk profile is important. It is also essential to check if the ETF's expected returns closely match the index it tracks to ensure consistency. A well-structured investment plan is also a must. Such a long-term roadmap helps with a rational investment approach.
2. Liquidity
Keeping an eye on the liquidity of an ETF is essential to recovering money on sale and avoiding losses. The ETF may trade at a premium or a discount if the underlying assets aren't particularly liquid and affect the sale or purchase price. Make sure you choose a liquid ETF so you don't have to wait to redeem your holdings or incur losses because of lack of liquidity.
3.Structure and Internal Functioning
It is important to understand the structure and functioning of an ETF as it affects the risk levels, commissions, and probable losses. Investors can measure the risk exposure by assessing whether an ETF is a full replica or synthetic. A full replica would mean the investment is in the same assets as the index. A synthetic ETF would mean it is backed by derivatives.
4.Profitability
New investors shouldn't make the mistake of assuming that past performance will also persist in the future. Historical trends should only be considered for consistency.
5.Keep Volatility in Mind
Volatility in ETFs can result from a lack of liquidity or volatility in underlying assets. If you urgently need money invested in the ETF and end up selling during a downturn, you might incur a loss. That's why investing with a long-term perspective and perhaps seeking help from an expert can be beneficial.
6.The ETF Market
Investors should be vigilant about the geographic exposure of ETFs. Overexposure to one particular market can be of higher risk. Investors should diversify their portfolios geographically and by the types of assets to lower such risks.
Best Practices for Investing in ETFs
Investors can maximise the benefits of ETF investments by keeping in mind the following:
- Run a thorough research on the composition and investment strategy of the ETF.
- Draw up a long-run investment plan with specific goals and contingent plans.
- Ensure regular monitoring of the ETFs and make portfolio adjustments as required.
- Keep in mind the associated expenses and commissions and avoid profit erosion.
- Check the ETF liquidity before making investments.
- Know the structure and internal functioning of ETFs to control risk exposure.
- Study the past performance of the ETF to check consistency but avoid assuming the same about its future returns.
- Understand the factors affecting ETF volatility and refrain from trading during high volatility periods.
- Be mindful of ETF diversification according to geography and the type of assets to mitigate risks.
- Make sure to be tax-compliant to avoid any penalties.
Conclusion
ETFs can be suited for both beginner and experienced investors because of their liquidity, diversification, and low fees. Investors should understand the complexities of ETFs and adopt a strategic approach to go through the intricacies of the stock market effectively. However, investors should be aware of the common mistakes when investing in ETFs and follow the best practices.
Disclaimer:
The information herein is meant only for general reading purposes and the views being expressed only constitute opinions and therefore cannot be considered as guidelines, recommendations or as a professional guide for the readers. The document has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. The sponsor, the Investment Manager, the Trustee or any of their directors, employees, associates or representatives (“entities & their associates”) do not assume any responsibility for, or warrant the accuracy, completeness, adequacy and reliability of such information. Recipients of this information are advised to rely on their own analysis, interpretations & investigations. Readers are also advised to seek independent professional advice in order to arrive at an informed investment decision. Entities & their affiliates including persons involved in the preparation or issuance of this material shall not be liable in any way for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including on account of lost profits arising from the information contained in this material. Recipient alone shall be fully responsible for any decision taken on the basis of this document.
Mutual Fund Investments are subject to market risks, read all the scheme related documents carefully.
