Exchange-traded funds, or ETFs, are an easy way to begin investing. ETFs are fairly simple to understand and can generate impressive returns without much expense or effort. Here’s what you should know about ETFs, how they work, and how to buy them.
What is an ETF?
An Exchange Traded Fund, or ETF, allows investors to buy many stocks or bonds at once. Investors buy shares of ETFs, and the money is used to invest according to a certain objective. For example, if you buy Nippon India ETF Nifty BeES ETF, your money will be invested in the 50 companies in that index.
ETFs vs. mutual funds
One common question is how Exchange Traded Funds (ETFs) differ from mutual funds, as 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 which means that the value of a mutual fund depends upon the performance of the NAV and can only be determined after the market closes for the day. 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 NSE and BSE. Instead of investing a set amount, you choose how many shares you want to purchase. Because they trade like stocks, ETF prices fluctuate continuously throughout the trading day, and you can buy and sell shares of ETFs whenever the stock market is open.
Important things to know about ETFs
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 HDFC Sensex ETF. Active ETFs hire portfolio managers to invest their money. The key takeaway here is: 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, expense ratio for HDFC Sensex ETF is 0.05%
- Dividends and DRIPs — Most ETFs (Exchange Traded Funds) pay dividends. You can choose to have your ETFs dividends paid to you as cash, or you can choose to have them automatically re-invested through a dividend reinvestment plan or DRIP.
Common types of ETFs available today
let’s look at some common types of ETFs.
Equity ETF –Equity ETFs track an index of equities. You can choose ETFs covering large businesses, small businesses, or stocks from a specific country. Equity ETFs also let you target sectors that might be doing well at that time, like tech stocks or banking stocks, which makes them a popular choice.
Gold ETF – This is a commodity exchange-traded fund primarily involving physical gold assets. Purchasing shares of this company allows you to become the owner of gold on paper, without the burden of asset protection.
Debt ETF/Bond RTF – Similar to stock ETFs, these funds own a portfolio of bonds instead of stocks.
Currency ETF – Currency ETFs will invest in either a single currency, like the US dollar, or a basket of currencies. The ETF will either invest in the currency directly, use derivatives, or a mix of the two.
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.
Steps to Investing in ETFs
- Open a brokerage account.
- Choose your first ETFs.
- Let your ETFs do the hard work for you.
Step 1: Open a brokerage account
You’ll need a brokerage account before you can buy or sell ETFs. The majority of online brokers now offer commission-free stock and ETF trades, so cost isn’t a major consideration. The best course of action is to compare each broker’s features and platform. If you’re a new investor, it might be a good idea to choose a broker that offers an extensive range of educational features, such as Zerodha or Upstox , but there are several other excellent brokers to choose from.
Step 2: Choose your first ETFs
For beginners, passive index funds are generally the best way to go. Index funds are cheaper than their actively managed counterparts, and the reality is that most actively managed funds don’t beat their benchmark index over time.
With that in mind, here’s a list of ETFs for beginners who are just starting to build their portfolios:
5 Excellent ETFs for Beginners
Step 3: Let your ETFs do the hard work for you
It is important to keep in mind that ETF’s are generally designed to be maintenance-free investments.
Newer investors tend to have a bad habit of checking their portfolios far too often and making emotional, knee-jerk reactions to major market moves. In fact, the average fund investor significantly underperforms the market over time, and over-trading is the main reason. So, once you buy shares of some great ETFs, the best advice is to leave them alone and let them do what they’re intended to do: produce excellent investment growth over long periods of time.