What is an ETF?
Exchange-Traded Funds, or ETFs, are essentially Index Funds that are listed and traded on exchanges like stocks. An ETF is a basket of stocks, bonds, or commodities that reflect the composition of an Index, like S&P CNX Nifty or BSE Sensex. The current trading value of ETFs is derived from the net asset value of underlying stocks/ commodities that it represents.
ETFs have gained wider acceptance, especially from risk-averse traders, as they are suitable for investors who find it difficult to identify stocks for their portfolio. Various mutual funds also provide ETF investment products that attempt to replicate the benchmark indices on the BSE & NSE. Such Exchange Traded Funds provide returns that closely correspond to the total returns of the securities represented in the index.
ETFs vs. mutual funds
One common question is how ETFs differ from mutual funds since the basic principle is the same.
The key difference between these two types of investment vehicles is how you buy and sell them. Mutual funds are priced once per day, and you typically invest a certain amount. Mutual funds can be purchased through a brokerage or directly from the issuer, but the key point is that the transaction is not instantaneous.
On the other hand, ETFs trade just like stocks on major exchanges such as the Nifty and Sensex. Instead of investing a certain amount, you choose how many shares you want to purchase. Because they trade like stocks, ETF prices continuously fluctuate throughout the trading day, and you can buy shares of ETFs whenever the stock market is open.
Understanding ETF basics
Before we get any further, there are a few concepts that are important to know before you buy your first ETFs.
Passive vs. active ETFs: There are two basic types of ETFs. Passive ETFs (also known as index funds) simply track a stock index, such as the Nifty 50. Active ETFs hire portfolio managers to invest their money. The key takeaway: Passive ETFs want to match an index’s performance. Active ETFs want to beat an index’s performance.
Expense ratios: ETFs charge fees, known as the expense ratio. You’ll see the expense ratio listed as an annual percentage. For instance, a 1% expense ratio means that you’ll pay Rs.10 in fees for every Rs.1,000 you invest. All things being equal, a lower expense ratio will save you money.
Dividends and DRIPs: Most ETFs pay dividends. You can choose to have your ETF dividends paid to you as cash, or you can choose to have them automatically reinvested through a dividend reinvestment plan, or DRIP.
Pros and Cons of ETFs
Advantages to investing in ETFs:
- ETFs provide exposure to a variety of stocks, bonds, and other assets, typically at a minimal expense.
- ETFs take the guesswork out of stock investing. They allow investors to match the market’s performance over time, which has historically been quite strong.
- ETFs are more liquid (easy to buy and sell) than mutual funds. Online brokers make it easy to buy or sell ETFs with a simple click of the mouse.
- It can be extremely complicated to invest in individual bonds, but a bond ETF can make the fixed-income portion of your portfolio very easy.
Potential drawbacks of ETFs:
- Since ETFs own a diverse assortment of stocks, they don’t have quite as much return potential as buying individual stocks.
- ETFs are often low-cost, but they aren’t free. If you buy a portfolio of individual stocks on your own, you won’t have to pay any management fees.
How to start investing in ETFs
- Open a brokerage account.
- Choose your first ETFs.
- Let your ETFs do the hard work for you.