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Exchange Traded Funds (ETF) : Meaning, Types & Benefits

Last Updated : 30 Nov, 2023
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What are Exchange Traded Funds (ETF)?

Exchange-traded funds, commonly known as ETFs, are financial instruments that can be easily traded on a stock exchange like any other securities. ETFs are a combination of mutual funds and equities of the listed company. This means that ETFs are a bundle of different classes of securities activating the feature of diversification and the flexibility of equity (stock). In simple words, ETFs are a bunch of stocks, debentures, bonds, and other assets combined together as a single fund, that can be traded freely on a stock exchange. However, it shall be noted that ETFs are different from Mutual Funds on the following basis:

  •  ETFs are freely traded on a stock exchange and can be sold and bought by the investor, which is not possible in the case of Mutual Funds.
  • Unlike Mutual Funds that are allotted Net Asset Value (NAV) at the end of each trading period, ETF’s value is highly fluctuating that keeps on changing throughout the day depending on its demand and supply and replicates the return on indexes, which are likely to be different from the actual index.
  • ETFs as compared to Mutual Funds are more cost-efficient.

 Exchange Traded Funds (ETF)

ETFs are created and designed to track a particular market index or sector. At present, there are several ETFs functioning on the basis of sector-specific, asset class-specific, country-specific, and broad-market indexes. When an investor buys shares in an ETF, he/she buys a portion of the underlying assets that make up the fund. However, it shall be noted that like Mutual Funds, investment in ETFs is also made according to the investor’s financial goals, management cost, trading flexibility, risk appetite, and portfolio requirements.

How do ETFs Work?

A fund provider, often known as an “authorized participant” (APs), creates a diversified portfolio of assets, such as stocks, debentures, bonds, currencies, or other securities. The assets are typically selected by the fund providers, who then form a fund to track and replicate the performance of different market indexes. Funds (ETFs) are then divided into shares, that are listed on the stock exchange and are sold to the investors. Let’s understand this in steps:

1. Creating ETFs: The “authorized participant” (APs) creates a portfolio of diversified assets and then tracks the performance of the index that ETFs aim to hit.

2. Listing and Trading: Once the ETFs are created, it is divided into shares that are listed on a stock exchange and are capable of being traded freely like any other stock. An investor just buys a share in ETFs and has no ownership right over the underlying assets in the Fund.  

3. Pricing: ETFs have a manager who continuously quotes the bids and replicates the prices of ETFs along with ensuring that the prices of ETFs remain aligned with the Net Asset Value (NAV) of the underlying assets. 

4. Tracking the performance: The Investing managers continuously evaluate the performance of the ETFs to represent the performance of the underlying sector or index it aims to track. ETFs are adjusted timely to image the changes in the index composition.

5. Charging Fee: Like Mutual Funds managers, ETF’s investment managers also charge a fee for their services as management fees, administrative fees, and other operational costs. However, such costs are lower than that charged by Mutual Funds managers.

6. Buying and selling: After investing and owning a share in ETFs, investors are free to buy and sell the shares on a stock exchange at prevailing market prices. Such prices are determined by the demand and supply in the market and are likely to be different from the NAV of the underlying assets in the fund.

Types of ETFs

ETFs are created to track the performance of different indexes or sectors, and depending on the sector, underlying assets, and investment strategies, ETFs can be divided into the following types:

1. Equity ETFs: ETFs that invest in the equity of the companies listed on a stock exchange are Equity ETFs. Such ETFs track the performance of different industry sectors, geographic regions, and market capitalization like small-cap, mid-cap, and large-cap.

2. Fixed Income ETFs: These types of ETFs are focused on all types of fixed-income-yielding securities, like bonds and debentures. It invests in all categories of bonds, including government bonds, corporate bonds, treasury bonds, municipal bonds, and agency bonds.

3. Commodity ETFs: These ETFs invest in physical commodities like gold, silver, oil, or agricultural products or invest in companies involved in their production, exploration, or distribution, with an aim to track the price movements of the underlying commodity. Commodity ETFs provide diversification or a hedge against inflation or other economic condition.

4. Currency ETFs: Currency ETFs invest and focus on currencies of different countries or a bunch of currencies, allowing the investor to enter the foreign exchange market. Such ETFs track the performance of specific currencies, or specific currency pairs, or provide exposure to a basket of currencies.

5. Real Estate ETFs: Real Estate ETFs invest in real estate properties, or in real estate investment trusts (REITs) or real estate operating companies (REOCs), that own, operate, or finance income-generating real estate properties. These ETFs allow investors to gain exposure to the real estate market, and track the performance of specific types of properties, such as residential, commercial, or industrial real estate. 

6. Factor ETFs: Factor ETFs aim to focus on different investment factors like value, financial goal, risk management, timeline, growth, etc. to gain exposure to specific investment strategies.

7. Multi-Asset ETFs: Multi-Asset ETFs invest in a diversified portfolio consisting of assets of different classes bound together in a bunch, so as to enjoy the benefits of a diversified investment approach in a single fund.

8. Sector ETFs: ETFs that invest in specific sectors or industries, such as technology, healthcare, finance, energy, renewable energy, artificial intelligence, or consumer goods are Sector ETFs. These aim to track the performance of specific sectors or industries to implement a sector rotation strategy or get a specific investment view. 

The above-mentioned ETFs are some out of the pool of ETFs. It is important to analyze each type of ETF before making investment decisions and to determine the type of ETF that is confined to the investment goals and risk tolerance of an investor.

Benefits of Investing in ETFs

ETFs have gained popularity in recent years because of their unique advantages over other investment funds. Some of these benefits have been discussed below:

1. Diversification: ETFs are simply a bundle of different classes of assets bound together in a single fund. This enables investors to grab the benefits of diversified investment in one shot. The diversified feature of ETFs helps investors to cope with the risk factor associated with the financial market. A portfolio safeguards the investment interest of investors by scattering the investment into different sectors, so as to balance the losses of one sector against the profit of another sector.

2. Cost-Effective: ETFs have caught the attention of investors because of their low management cost as compared to mutual funds. ETFs are traded freely on a stock exchange and track an underlying index that can be handled passively without incurring much cost. Investors have to bear the low managing costs which increase the overall return in a long run.

3. Transparency: ETFs present the details of their holdings along with the index of the underlying assets at the end of each trading day, making it easier for investors to monitor and track the performance of ETFs fund. This provides aid in making investment decisions. A detailed report of the holdings on a daily basis makes ETFs a trustworthy investment t fund.

4. Flexibility: ETFs are listed on a stock market and can be easily sold and bought by investors at any point of time, making them a highly liquid financial instrument. Liquidity also offers flexibility and convenience to investors as they can adjust their holdings according to the changing market conditions or investment objectives.

5. Tax- Benefits: ETFs are considered to be tax-efficient funds as they witness low portfolio turnovers and generate few capital gains in comparison to other investment funds. Besides this investing in ETFs makes it easy to plan out the selling of the shares in such a manner that the high taxes on the short-term capital gains can be avoided. As a result of this ETFs proves to be tax saving investment for investors.

Risks of ETFs

Like any other investments, ETFs are also associated with a certain degree of risk. Some of the risks that surround ETFs include:

1. Market Risk: ETFs being investment funds are subject to market risk. This means that any change in the market condition directly affects the market value of the ETFs. If any market index or sector shows poor performance, the value of ETFs of that sector is adversely affected, incurring losses to the investors.

2. Liquidity Risk: Although it is said that ETFs are freely traded on a stock exchange, but their liquidity depends on the trading volume and market activity. ETFs that have low trading volume are difficult to sell at desired prices, especially at a time of market downfall.

3. Tracking Error: ETFs are designed to track the performance of various indexes, but in reality, the ETFs indexes show a slight difference between the benchmark performance and the performance of ETFs. Such deviation in performance may spoil the expectation of the investors in terms of return.

4. Interest Rate Risk: ETF’s investment in fixed-income securities earns a fixed interest at a specific period of time, but is also subject to Interest Rate Risk. When the rate of interest on such securities rises, the market value of such ETFs decreases causing a loss to the investors.

5. Tax Risks: ETFs are subject to taxes and may increase the tax burden of the investors. If the ETFs earn a handsome amount of capital gain, the tax burden of the investor multiplies. In addition to this ETFs having a high portfolio turnover creates a tax burden on the shoulder of investors, even if ETF shares are not been sold.

How to Invest in ETFs?

The process of investing in ETFs can be complex and may require professional assistance from financial experts. There are several steps to be followed in order to invest in ETFs: 

1. Determining Financial Objective: The first step in any investment process is to get clarity about the investor’s financial goals in terms of return, timeline, and risk appetite. This helps in selecting the right ETFs as per the goals and risk tolerance of the investor. This is further followed by asset allocations under which ETFs tracking the performance of different asset classes are analyzed and selected as per the investing goals of the investors. Generally, a diversified portfolio is constructed to spread out the risk.

2. Selecting a Broker and Opening a Brokerage Account: Once the goals are set and underlying assets in ETFs are decided, the investor is required to select the brokerage firm either online or offline to trade in ETFs. Factors like fees, commissions, trading tools, and customer service are taken into consideration for this purpose. Once the brokerage firm is selected, a brokerage account is opened along with Demat account in the name of the investors, to hold and trade in ETFs. Then, funds are transferred from the investor’s bank account to the brokerage account.

3. Trading in ETFs: Once the Brokerage account is funded, Investor is in a position to buy the ETFs shares through the brokerage firm or platform. A specification about the type of ETFs, number of shares in ETFs, market order, and amount to be invested is required from the investor’s side. Reviewing all the details before confirming the investment is always better.

4. Overseeing and Managing ETFs: Once the investment in ETFs is made, it becomes necessary to monitor and manage the ETFs regularly. A detailed report about the ETF holding and the value of the underlying assets is presented by the ETF Company at the end of the trading day, making the management of the investment easier. Further, this also helps the investors to rebalance their shares as per the market condition in order to remain intact to the investment goals.

5. Seeking Professional Help: ETFs are subject to market risk and hence require expert management to achieve the desired return. The qualified managers suggest suitable ETFs as per the goals of the investors. They also help in formulating and implementing personalized investment strategies in order to achieve the expected financial goals.

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