An Exchange Traded Fund (ETF) tracks an underlying index. It is a passive investment instrument where the fund will invest in the constituents of the underlying index. Thus, to simplify, an ETF is a basket of securities that tend to match an Index's composition, keeping the proportion similar to its index. Since ETFs track an index’s performance, they do not require active management by the fund manager. They do not aim at outperforming their indices either.
ETFs are traded on the stock exchange and just like any other share, their prices keep moving through working hours of a stock exchange. The price at which a unit of ETF is bought or sold is derived on the basis of the market price at which the trades are executed by the buyer and the seller which is similar to buying/selling any other stock on the exchange. You need to have a Demat account to be able to invest in ETFs.
ETFs generally have a low expense ratio as compared to other active
Mutual Funds since they do not have to undergo the stock picking process based on their research and active fund management ideas.
While they can be a little more complicated to understand, they have several advantages over other mutual funds.
• The ease of use and low cost make them attractive as an investment tool.
• They can be a good choice for first-time investors looking to try out financial markets.
• Moreover, some broad market-based ETFs can form the core of an investment portfolio for the investors.
How Do ETFs Work?
ETFs are similar to other mutual funds in terms of the way they are constructed. They are a collection of securities (stocks, bonds, etc.) across which investment money is spread. This pool is made up of money contributed by willing investors who get issued units or shares in return for their investment.
If you were to buy equity shares of a single company, you would have ownership in only that particular stock. However, the same sum of money invested in an ETF allows you to own several different stocks and get the benefit of diversification as your investment is spread across several stocks. This would also help to mitigate risk as compared to having an exposure to a single stock investment.
While the basic structure of an
ETF broadly remains the same, the funds are of several types.
Types of ETFs
(a)Equity ETFs:
These are the funds that come to mind when one mentions the term ETF. They track a broad market stock index like the S&P BSE Sensex or Nifty 50; sectoral index like Nifty Bank or Nifty IT; thematic index like Nifty Infrastructure or strategy index like Nifty 50 Value 20 Index. Moreover, there are a few International ETFs available as well which track the popular index of the international market like Hang Seng or NASDAQ 100. These ETFs allow investors to take the first step into equity investing by giving them a flavour of what investing in stock markets feels like. By investing in such an ETF, investors get a chance to own all stocks in a popular index and help their portfolio post near index-matching returns (subject to expense ratio and tracking errors).
(b)Fixed Income ETFs:
These funds replicate an underlying bond index comprising securities like G-Secs, State Development Loans (SDLs), Government Companies’ Bonds, Money Market instruments, etc. They can help reduce a portfolio’s volatility by diversifying investment into these securities. At present, in India, investors can buy liquid ETFs, government bond ETFs, and ETFs investing in public sector companies' debt issues.
(c)Commodity ETFs:
These funds help investors add commodities to their portfolio. These can be in the form of derivative contracts which track the price of a commodity one wants to invest in. In India, currently the regulation allows only Gold ETFs. An investor in
Gold ETF would indirectly get an exposure to physical gold with 99.5% purity. The objective here is to track the price performance of physical gold (subject to expense ratio and tracking errors).
Please note that the above list of ETFs is not exhaustive. As per financial inventions, many new ETFs have been introduced in the market, especially in developed regions like Europe and the US. These basic types of ETFs are a great way to get started on your passive investment journey. It is advised to understand the risks of each kind of ETF and then invest money.
Mutual Fund Investments are subject to market risks, read all the scheme related documents carefully.
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