Exchange-Traded Funds (ETF) Types and Benefits

What are Exchange-Traded Funds?

Exchange-Traded Funds are securities traded in the market similar to stocks which track an index, group of same sector stocks, commodities, or bonds. In other words, Exchange-Traded Funds (ETFs) are those funds that track indexes such as Nifty 50, Nifty Next 50, Nifty small cap fund, etc.  However, the difference between index funds and ETFs is that unlike index funds, ETFs do not try to beat the market or perform better than the market, instead, they replicate the market. ETFs are traded on the market just like stocks, where the value is determined by the underlying asset and price is determined by demand and supply which changes continuously throughout the market hours.

Who Manages Exchange Traded Funds and How?

ETFs are managed by a fund manager and they are managed passively. Whereas mutual funds are actively managed by a fund manager primarily to safeguard the investment and outperform the market. 

The idea of ETFs is primarily to copy an index fund stock by stock and ratio by ratio which gives the same returns as the index. In this case, you do not need a fund manager to tell you which stock to buy, hold, and sell. 

Because the fund is passively managed the management fee is quite low compared to a mutual fund fee which charges a high management fee, usually 1 to 2%, due to continuous changes in the portfolio in the aim to beat the market.

Cost of Investing in ETFs

When an investor buys an ETF, the costs incurred are similar to buying a stock such as brokerage charges etc. When it comes to mutual funds your expenses are paid by mutual funds but you pay a management fee which is higher than the ETFs. 

ETFs are traded at much higher volumes because they represent a basket of stocks that is highly liquid and diversified. Unlike mutual funds which change price only after the closing bell, ETFs are priced continuously during the market hours.

Types of ETFs

Actively managed ETFs:

These are managed by a fund manager actively picking stocks for investors, which would cost more to the investors in terms of management fees.

Passive ETF:

These ETFs are trying to replicate a benchmark index or a sector index such as Nifty 50.

Bond ETF:

The primary aim is to provide investors with regular income. Bond `ETFs are the combination of certain types of bonds and the returns are based on the type and performance of different bonds such as government bonds, corporate bonds, etc. They do not have a maturity date, unlike bonds.

Stock ETF: 

Stock ETFs are created by a basket of stocks related to the same industry or sector. The primary goal is to diversify and provide potential growth opportunities. Unlike mutual funds, stock ETFs do not charge much fees.

Industry or Sector ETF:

This focuses on a specific group of stocks operating in the same industry. Such as HDFC Nifty IT signifies Information technology stocks ETF.

Commodity ETF:

Invests in commodities such as crude oil, cotton, and others. The presence of commodity ETF in a portfolio hedges against the downturn of the market.

The ETFs market is worth more than 850 crores in the Indian NSE stock exchange as of 2024. 

How to Invest in Exchange-traded funds?

It is really simple and straightforward to invest in ETFs nowadays. Almost every brokerage is providing services to buy, hold, and trade ETFs in the brokerage or trading account. All you need to do is to open an account with a popular brokerage in your area. Such as IIFL Securities or Interactive Brokers Ltd etc, whichever is suitable for your understanding.

Once you have an account loaded with cash in the trading account the second thing you need to do is find the best ETFs for yourself. Before getting to conclusions or believing some random website’s recommendations, try to research ETFs. By setting a filter or priority such as fee, past years performance, volume, liquidity, sector, etc.

Do ETFs give Dividends?

Of course, stocks do pay a dividend but when the stocks held by the ETFs pay a dividend they are reinvested.

Does an ETF give the same returns as an Index?

ETFs are supposed to mimic a benchmark index. However, there is a difference between the index and ETF portfolio return, this is called Tracking Error. 

This occurs due to various expenses such as admin, management, marketing, and brokerage. Sometimes the ETF may outperform due to the dividend reinvestment. A well-managed ETF has low Tracking Error.

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Benefits of Investing in ETFs

ETFs can be bought and sold just like stocks in addition they can be traded like stocks. For example you can sort and sell them and hold them for the long term etc. 

When you buy an ETF it comes with a diversified portfolio as it contains a basket of stocks in which some stocks outperform and few underperform.

Allocation of assets could be a difficult task for individual investors. ETFs play a major role in providing them with various choices for diversified and proper asset allocation in terms of cost and potential opportunities.

Every investor, either individual or institutional will come across a time when one would be required to invest for the short term. ETFs are the best place to park your money. Because they ensure the safety of the principal and provide market return which is better than FD and bonds.

In addition, it can be used for hedging risk by short selling. Using trading techniques between futures and the cash market.

Why Are ETFs So Popular Among Investors?

The popularity of ETFs has grown rapidly over the last two decades—and for good reason. Investors, both retail and institutional, are drawn to ETFs due to their flexibility, cost-efficiency, and transparency. Unlike mutual funds, which are priced once a day after the market closes, ETFs trade like stocks throughout the trading session. This intraday liquidity makes them a preferred tool for both active traders and long-term investors.

Moreover, ETFs are designed to mirror the performance of a specific index, commodity, or sector, offering instant diversification in a single purchase. This is especially useful for beginners who may not have the expertise or time to build a well-balanced portfolio on their own.

Liquidity and Transparency in ETFs

Liquidity in ETFs depends on two layers: the trading volume of the ETF itself and the liquidity of the underlying securities in the ETF portfolio. Even if an ETF doesn’t have high trading volume, it may still be liquid due to the liquidity of its underlying assets.

Transparency is another strong point for ETFs. Most ETFs publish their holdings daily, allowing investors to see exactly what they own. This is in contrast to mutual funds, which typically disclose holdings on a monthly or quarterly basis.

Tax Efficiency of ETFs

One of the lesser-known advantages of ETFs is their tax efficiency. ETFs generally have lower capital gains distributions compared to mutual funds. This is because of the unique “in-kind” creation and redemption mechanism of ETFs, which allows fund managers to avoid triggering taxable events when adjusting the portfolio. As a result, investors may face lower tax liabilities, especially in countries where capital gains are taxed.

Risks Involved in ETFs

While ETFs offer many benefits, they are not risk-free. Here are a few risks investors should be aware of:

1. Market Risk: Like any equity investment, ETFs are subject to market volatility. If the underlying assets lose value, so does the ETF.

2. Tracking Error: As discussed earlier, the performance of an ETF may slightly differ from the index it mimics due to costs and management inefficiencies.

3. Liquidity Risk: Not all ETFs are equally liquid. Low trading volumes can result in wider bid-ask spreads, leading to higher trading costs.

4. Sector Concentration Risk: ETFs focusing on a specific industry may experience more volatility compared to diversified ETFs.

5. Currency Risk: International ETFs that invest in foreign markets may expose you to fluctuations in currency exchange rates.

Comparison: ETFs vs Mutual Funds vs Stocks

Global vs Domestic ETFs

In India, investors can choose from both domestic ETFs (tracking Indian indices) and international ETFs (tracking global markets). Global ETFs offer Indian investors a way to diversify geographically and gain exposure to developed economies like the U.S., Europe, or emerging markets like China.

Examples:

• Domestic ETF: Nippon India Nifty 50 ETF

• International ETF: Motilal Oswal Nasdaq 100 ETF

However, keep in mind that global ETFs can expose investors to geopolitical risks and currency volatility.

How to Evaluate an ETF Before Investing

Here are the key metrics you should consider:

• Expense Ratio: Lower is better. It tells you how much you pay annually as a percentage of your investment.

• Tracking Error: The lower the tracking error, the better the ETF mimics its benchmark.

• Liquidity: High daily volume and low bid-ask spread indicate better liquidity.

• Assets Under Management (AUM): A higher AUM generally signals investor trust and better stability.

• Historical Returns: While past performance doesn’t guarantee future results, it helps set expectations.

Real-Life Example: Investing ₹10,000 in an ETF

Let’s say you want to invest ₹10,000 in the Nifty 50 ETF. Here’s a simplified breakdown:

• If the current price of the ETF is ₹200, you can buy 50 units.

• If Nifty 50 rises by 10% in the next year, your ETF may also grow by approximately 10%, giving you a portfolio value of ₹11,000 (excluding fees).

• If you were to sell, you’d incur standard brokerage and transaction charges, similar to stock trading.

Frequently Asked Questions (FAQ) on Exchange-Traded Funds (ETFs)

1. What is an ETF in simple words?

An ETF is a type of investment fund that is traded on stock exchanges, just like individual stocks. It holds a collection of assets, such as stocks or bonds, and aims to mimic the performance of a specific index or sector.

2. How is an ETF different from a mutual fund?

Unlike mutual funds, which are priced only once a day, ETFs can be traded any time during market hours. ETFs generally have lower fees and are more tax-efficient than mutual funds.

3. Can beginners invest in ETFs?
Yes. ETFs are beginner-friendly because they offer instant diversification, lower cost, and do not require constant portfolio monitoring.

4. Do I need a Demat account to invest in ETFs?
Yes, since ETFs are traded like stocks, you need a Demat and trading account with a registered brokerage.

5. Are ETFs safe investments?
ETFs are relatively safer compared to individual stocks due to diversification. However, they are still subject to market risks.

6. Can I get regular income from ETFs?
Yes, some ETFs like bond ETFs or dividend-paying stock ETFs can provide regular income. However, not all ETFs pay dividends.

7. What is tracking error in ETFs?
Tracking error is the difference between the performance of an ETF and the index it follows. Lower tracking error indicates better performance in mirroring the index.

8. Is there a lock-in period for ETFs?
No, there is no lock-in period for ETFs. You can buy and sell them anytime during trading hours.

9. Are there tax benefits with ETFs in India?
Yes. Equity-oriented ETFs held for more than one year are subject to long-term capital gains tax at 10% (beyond ₹1 lakh gain). Short-term gains (under one year) are taxed at 15%.

10. Can I invest in foreign markets using ETFs?
Yes, international ETFs let you invest in global indices such as the S&P 500, Nasdaq 100, etc., from your Indian trading account.