What is an ETF? Should you invest in Exchange traded funds?

The best part about mutual fund investing is that are plenty of investment products under broad categories which makes it possible for almost everyone to find a scheme that is aligned with their investment objective. For example, if building an emergency fund is on your mind you can consider investing in a liquid fund that falls under the debt scheme category and is a mutual fund scheme that offers high liquidity. If your investment objective is to take some higher risk to earn better returns, you can consider investing in a small cap fund. Investors who want to save taxes this fiscal year can consider investing in Equity Linked Savings Scheme (ELSS).

Similarly, investors who wish to invest in a mutual fund scheme whose units can be traded at the live market price are referred to as exchange traded funds (ETFs). 

What is an exchange traded fund?

An ETF is an open ended scheme that can only be traded using a demat account. Exchange Traded Funds are listed at the stock exchange just like company stocks which makes it possible for investors to enter or exit this fund during live trading hours. Investors can book profit and sell their ETF units similar to how traders buy and sell shares at the exchange.

Investors seeking equity exposure can consider investing in exchange traded funds. What distinguishes an ETF from direct equities is that ETFs have a diversified investment portfolio. A diversified portfolio is void of concentration risk whereas investments in direct equities have a very high concentration risk. ETF funds are ideal for long term investing, and investors can target their life’s financial goals which require a large commendable corpus like buying a new house or even a car. 

Difference between exchange traded funds and mutual funds

Parameter ETFs Mutual Funds
Risk management Exchange traded funds are passive funds which follow a passive management strategy Mutual funds offer active risk management
Modes of investing Investors need to have a demat account in order to trade with ETF units One can invest in mutual funds without any demat account
Low expense ratio Since there is very less participation of the fund manager in managing ETFs, they have a relatively low expense ratio Mutual funds that are actively managed have a high expense ratio as compared to passive funds like ETFs
Purchase price ETF units are traded live at the current NAV (net asset value) Mutual fund units can be only bought or sold once in a day at the NAV which is determined at the end of the day
How are returns earned ETFs track the performance of an underlying index or asset class without minimum tracking error Mutual funds earn by investing in a diversified portfolio of securities by generating risk adjusted returns

Should investors consider investing in exchange traded funds?

Investors should not only invest in ETFs because they have a low risk profile or can be traded at the live market price. They must invest if the investment objective of the ETF aligns with their investment goals. Investors must realize ETFs carry a very high investment risk and hence, they should determine their risk appetite before investing. ETFs offer passive management which means investors who are choosing mutual fund investors to benefit from the expertise of season fund managers should reconsider investing.

Those who wish to invest in ETFs must be ready to expose their investment portfolio to the market’s volatile nature. Investors may need to have a very high risk appetite and a long term investment horizon to allow their ETF fund to generate maximum returns.