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What is an exchange-traded fund (ETF)?

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Like other mutual funds, an exchange-traded fund (ETF) is a pooled investment asset. ETFs may be bought or sold on a stock market in the same manner as conventional stocks, unlike mutual funds. Still, they usually follow a specific index, sector, commodity, or other asset. An exchange-traded fund (ETF) can monitor many asset classes, ranging from a broad assortment of securities to the value of a single commodity. Even more, ETFs may be set up to reflect certain investing philosophies.

Table of Contents

  1. ETF meaning
  2. How do ETFs Work?
  3. Types of ETFs
  4. Key Features
  5. Benefits of diversification with ETFs
  6. Practical considerations when investing in ETFs
  7. How to Invest in ETFs?

ETF meaning

An exchange-Traded Fund or ETF definition is an exchange-traded product that represents a diversified portfolio of stocks, bonds, or commodities. Like individual stocks, ETF units can be readily exchanged at the prevailing market price throughout the trading session.

Knowing what Exchange-Traded Funds are follows specific measures, such as the CNX Nifty or the BSE Sensex. You buy a piece of an ETF's portfolio when you buy units. This portfolio is meant to copy the yield and profits of the ETF's index, subject to tracking error. Diverging from the goal of outperforming their benchmark index, ETFs prioritize tracking the broader market's performance.

ETFs trade on stock markets like common stocks, which makes them different from standard mutual funds. As traders buy and sell shares on the exchange, the market price of an ETF changes throughout the day. The supply and demand for an ETF's units determine its market price. The net asset value of the stocks that make up the ETF portfolio determines this trade value.

How do ETFs work?

1. Basket of securities: ETFs are like baskets that hold a collection of securities, such as stocks, bonds, or commodities, often tracking specific indexes or sectors.

2. Trading on stock exchanges: Unlike traditional mutual funds, ETFs are traded on stock exchanges like individual stocks, allowing buying and selling throughout the trading day.

3. Tracking performance: ETFs aim to replicate the performance of the underlying assets. For example, an ETF tracking the S&P 500 mirrors the returns of that index.

Types of ETFs

Equity ETFs: Track stock market indexes like the S&P 500 or specific sectors (e.g., technology, healthcare). Dividend ETFs focus on high-yielding companies.

Bond ETFs: Track bond indexes (e.g., government or corporate bonds) or focus on maturity or credit quality-based bonds.

Commodity ETFs: Track the prices of commodities like gold, oil, or agricultural products, and can be physically-backed or futures-based.

Currency ETFs: Track exchange rates of foreign currencies against the US dollar or other currencies.

Inverse ETFs: Aim to deliver the opposite of the daily performance of their index, making them highly risky and not suitable for long-term holding.

Leveraged ETFs: Amplify daily returns of an index (e.g., a 2x leveraged ETF aims for twice the return), but they are also risky and not ideal for long-term holding.

Smart Beta ETFs: Employ alternative investment strategies beyond market capitalization, focusing on factors like value, momentum, or quality.

Key Features:

Market trading: Unlike mutual funds that are valued post the market hours on each trading day, ETFs are bought and sold on stock exchanges, providing investors with the opportunity to trade them out at market prices during trading hours, unlike most mutual funds that are usually valued at the NAV by the end of the trading period.

Diversification: Most of the time, ETFs try to mirror an underlying index, commodity, or composite asset, subject to tracking error. The natural diversity in this spreads risk across many stocks, exposing buyers to different markets or sectors.

Liquidity: Being traded in stock exchanges makes ETFs highly liquid. It provides a wide range of market activities like entering and exiting at the times of market hours plus lower bid-ask spreads, more than any other liquid investment.

Transparency: ETFs usually make disclosures daily, providing investors with information about their assets. Transparency helps investors to make the right decisions.

Cost efficiency: Most of the time, these are less expensive than professionally managed funds. This is due to their passive management approach, which involves tracking an index rather than relying on active fund managers.

Benefits of diversification with ETFs

  • Easy diversification: ETFs track indexes, inherently providing diversification, as indexes typically consist of various securities.
  • Risk mitigation: Diversification can mitigate risk as the investment is not dependent on the performance of just a few stocks.
  • Simplicity: ETFs offer a simple and cost-effective way to invest in multiple securities as compared to choosing individual stocks.
  • Cost efficiency: ETFs are passively managed because they replicate a stock market index. The fund manager, therefore, does not have to play a major role in portfolio selection or management. This reduces administrative costs and therefore, the expense ratio of such funds.
  • Trading flexibility: ETFs can be bought and sold throughout the trading day at market prices. This intra-day trading feature provides investors with the ability to react quickly to market changes, take advantage of price movements, and implement various trading strategies, such as stop-loss orders and limit orders. In contrast, mutual funds are typically bought or sold at the end of the trading day at the net asset value (NAV) price, which does not allow for the same level of responsiveness to market conditions.
  • Transparency: ETFs are known for their transparency, as they disclose their holdings daily. This lets you see exactly what you are investing in and make informed decisions about your portfolio.

Practical considerations when investing in ETFs

  • Underlying index: There are numerous types of ETFs, tracking different indices. These include equity ETFs, debt ETFs, commodity ETFs and more. Familiarise yourself with the various ETF options and the underlying indices. Choose one that aligns with your risk appetite, investment horizon and goals.
  • Expense ratios: When you invest in ETFs, it's crucial to consider the fees, also known as expense ratios. It's important to compare these costs across different ETFs to ensure you get the best value for your investment.
  • Tracking error: Evaluating how closely an ETF tracks its underlying index is important. A lower tracking error indicates closer alignment with the index.
  • Diversification: Investigate whether the ETF offers the level of diversification you want. Some ETFs may focus on specific sectors, while others may provide broader exposure.

How to invest in ETFs?

1. Open a brokerage account: Choose a reputable brokerage firm and open a Demat account for holding securities electronically.

2. Choose the ETF: Research ETFs based on your goals, risk tolerance, and investment horizon. Consider expense ratio, tracking error, liquidity, and past performance.

3. Place an order: Log into your brokerage account and place a market or limit order to buy the ETF.

4. Fund your account: Transfer funds to cover the cost of purchasing the ETF.

Conclusion

ETFs provide a flexible and diversified investment option, combining mutual fund diversification with stock trading flexibility. They offer an accessible tool for building and managing portfolios. However, investing in ETFs carries market risks, so thorough research, understanding your goals and risk tolerance, and consulting a financial advisor are essential steps before investing.

FAQs:

Are ETFs a suitable investment for beginners?

Yes, some ETFs can be a suitable investment for beginners due to their low costs, diversification benefits, and passive investment approach. However, it is essential for beginners to conduct thorough research and seek professional advice before investing.

Can ETFs be used for short-term trading?

Yes, ETFs can be used for short-term trading due to their intraday liquidity and ability to capture market movements. However, it is important to note that short-term trading involves higher risks and requires active monitoring of market conditions.

How do I determine the best ETFs for my investment needs?

To determine the best ETFs for your investment needs, consider factors such as expense ratios, performance history, underlying assets, and the fund manager's track record. Conducting thorough research and consulting with a financial advisor can help you make informed investment decisions.

How do ETFs help diversify a portfolio?

ETFs help diversify your investment portfolio by providing exposure to a broad range of assets, such as stocks, bonds, or commodities, within a single fund. This reduces the risk associated with individual securities, as potential gains in some assets can offset losses in others.

How can I choose the right ETFs for my portfolio?

To choose the right ETFs for your portfolio, consider your investment goals, risk tolerance, and time horizon. Evaluate the ETF's underlying index, expense ratio, liquidity, and performance history. Ensure it aligns with your diversification needs and investment strategy for optimal portfolio balance and potential returns.

Is ETF better than mutual fund?

ETFs and mutual funds each offer unique advantages, and neither is inherently better than the other. The choice depends on your individual investment goals, risk tolerance, and time horizon. ETFs are often cost-effective and flexible, while mutual funds provide active management and the potential for higher returns.

Is ETF tax free?

ETFs are not tax-free in India. They are subject to capital gains tax and dividend income tax.

Can I sell ETFs anytime?

Yes, ETFs can be sold during regular stock market trading hours. They are traded on exchanges, allowing intraday trading, unlike mutual funds that are traded only at the end of the day. However, market conditions and brokerage rules may affect how quickly you can sell.

How do I buy an ETF?

To buy ETFs, open a Demat and trading account with a broker, fund the account, and choose an ETF based on your goals. Place an order via the trading platform, monitoring its performance regularly. Ensure thorough research and consult a financial advisor for personalized guidance before investing.

What is an ETF example?

The Nifty 50 Index ETF tracks the performance of the Nifty 50 index, which includes the 50 largest and most liquid stocks on the NSE. By investing in this ETF, you gain exposure to a diversified portfolio of leading Indian companies across various sectors, offering easy access to diversification.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.

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