A complete guide to Exchange traded funds

Exchange traded funds are a popular investment tool among mutual fund investors. They can be bought and sold at the current market price during live trading hours. Investors can trade with ETF units just like they trade with stocks of companies. ETFs are listed on the market indices just like any other company stock. Investors get the best of both mutual fund and direct stock investing through exchange traded funds. Since these are passive funds, they have a relatively low expense ratio than active mutual funds. 

What is an exchange traded fund?

An Exchange Traded Fund (ETF) is an open ended scheme whose units can be traded throughout the day during market hours, which means investors can buy and sell these fund units at their current NAV (net asset value). The investment objective of an exchange traded fund is to generate capital appreciation by mimicking the performance of its underlying index or benchmark with minimal tracking error. 

How do ETFs work?

As mentioned earlier, ETFs offer the best of both mutual funds and stocks. They are bought and sold in the form of shares on all the exchanges where they are listed. Investors can enter or exit ETF funds by buying / selling their units at the fund’s live trading price throughout the day. Just like mutual funds, the NAV / market price of an ETF may fluctuate in value depending on the performance of its underlying assets and the basket of securities in which it invests. If the underlying assets of an ETF perform, its market price increases and vice versa.

ETFs are both active and passively managed. The portfolio manager of an active ETF carefully assesses its underlying securities and trades with them daily to help the scheme achieve its investment objective. On the other hand, passive ETF track the market trend of its underlying securities to generate capital appreciation. 

Benefits of investing in ETFs

When you buy shares of a single company, the performance of these shares will only depend on how the company performs in its coming quarters. When you invest in an ETF, you can invest in multiple company stocks thus avoiding any kind of concentration risk. For example, if you invest in an ETF that invests in the top 50 NIFTY companies, you will be able to invest different equities in small quantities rather than investing in just only single company stock.

Mutual funds have high management costs which are recovered through the expense ratio. A high expense ratio can take a significant chunk out of your overall capital gains. On the other hand, ETFs have a relatively low expense ratio which makes them a cost effective investment. ETFs are traded at the stock market and hence carry a relatively low expense ratio as compared to other mutual fund schemes. Investors can only buy or sell their mutual fund units based on their NAV which is declared at the end of the day. However, units of ETFs can be traded throughout the day, making them more liquid than mutual fund units. 

Volatility factor

ETFs may have several benefits over direct stock market investments and even mutual funds, but investors should bear in mind that these are market linked schemes too. The investment risk in ETFs is very high and hence, investors should first determine their risk appetite before investing. Just like any other mutual fund scheme, exchange traded funds do not guarantee returns.

Investors are expected to keep a well diversified investment portfolio and not only invest in any one scheme or asset class for income generation.