Exchange traded funds (ETF)
Exchange Traded Funds (ETFs) are essentially index funds that are listed and traded on exchanges like stocks. They track indexes like the Nifty, Sensex, or the banking index. When we buy units of an ETF, we are buying shares of a portfolio that tracks the yield and return of its native index. It is similar to a mutual fund that we can buy and sell during trading hours in real-time at the stock exchange. They enable investors to gain a broad exposure to entire stock markets and specific sectors at a lower cost than many other forms of investing. They can be held as units in our demat account, just like we hold shares.
Types of ETF
In India there are two ETFs which are popular namely index ETFs and gold ETFs. ETFs based on the Nifty Junior, Nifty, gold are commonly traded in India.
Advantages and disadvantages of using ETFs
The biggest advantage of an ETF is its lower expense ratio. Unlike actively managed funds where expense ratios could be between 2-3%, for ETFs the expense ratio is 1%. ETFs can be easily bought and sold like stocks during trading hours using our demat account with no additional paperwork. They allow investors to take the benefit of intra-day movements in the market, which is not possible with open-ended funds, which give us day end NAV. However, unlike mutual funds that do not need a demat account, for buying and selling ETFs we need a trading account and a demat account. Also since ETFs, are bought through a broker, every time we buy or sell we have to pay brokerage for our transaction. Since ETFs are yet to pick up in India, many ETFs have a small corpus and hence are illiquid, with a huge spread between the buying and selling price. Investors could lose out if they have to sell in an emergency
How are ETFs used by investors?
Asset allocation
For individuals it could be difficult to manage asset allocation given the cost involved. ETFs provide investors with exposure to broad segments of the equity markets. They enable investors to build customised investment portfolios in line with their risk taking ability and time horizon.
Diversification
Many a time investors are bullish on the market, but have not identified a particular stock to invest in. At such times they can park their funds in ETFs. Because ETFs are liquid, investors can participate in the market rally while deciding where to invest the funds for the longer- term, and avoiding potential opportunity costs.