Investing can be a tricky business with so many avenues available to choose from investors. ETFs or Exchange-traded Funds are one such investment option that operates the same as mutual funds but have the flexibility of being traded on an exchange like stocks.
In this article, we will talk about what is an exchange-traded fund, how it functions, what are different types of ETFs, the pros and cons, the return on ETFs, and lastly, things you should know before investing in ETFs.
What is an exchange-traded fund?
Exchange-traded funds as the name suggests can be traded on an exchange. ETFs can be based on individual security such as a commodity product or can expand to include a collection of different underlying assets. It provides investors with the opportunity to track various sectors, indexes, and a pool of equity stocks under one fund. Thus, proving an attractive means for diversification.
The same diversification applies to investing across different sectors, i.e. clean energy-based ETFs that track a range of companies in this space.
How do ETFs function?
ETFs function on the combined principles of mutual funds and stocks. Like mutual funds, ETFs contain a range of securities; they are more like open-ended mutual funds. Additionally, ETFs can be traded on exchanges like stocks. Exchange-traded funds are a good investment choice for investors having less familiarity and knowledge of the financial markets.
Because ETFs are traded on an exchange, their price tends to change during the trading day on a real-time basis. The level of fluctuations depends on the change in the underlying assets. For example, if an ETF is based on large-cap funds of BSE Sensex, any change in these large-cap funds would have a direct impact on the ETF. This is not the case with mutual funds as their price is measured only once a business day, which is also called the NAV (Net Asset Value).
What are the different types of ETFs?
Stock ETFs: Also known as equity ETFs, they contain different stocks from one sector or industry to track the performance, i.e. an ETF of pharmaceutical stocks. These ETFs have lower fees compared to mutual funds that invest in equity. Thus, favourable to pockets of investors.
Bond ETFs: Bond ETFs consist of bonds issued by a corporate, government, State, etc. as underlying assets and help investors with a regular income stream. The only difference between investing in bonds and bond ETFs is that the ETFs do not have a maturity date.
Active and Passive ETFs: Active ETFs are managed on a regular basis by fund managers and have the target to beat the benchmark. As a result, they are expensive to invest in compared to passive ETFs. Passive ETFs are designed to replicate the performance of benchmarks. They do not require active decision-making by fund managers and thus offer a good deal for novice investors with lower costs.
Sector or Industry-based ETFs: These ETFs are built with a focus on a particular industry or a sector. For example, investing in ESG (Environment, Social, and Governance) funds. This makes the investment concentrated, but as the investment is not directly made into underlying assets, the impact of change in underlying assets is not that severe.
Currency ETFs: Investors interested in the forex market whether national or international can leverage currency ETFs to passively benefit from changes in the underlying currency. They offer a great level of diversification and can act as a hedging tool against potential volatility in the currency market.
Commodity ETFs: Commodity ETFs allow investors to get the benefit from investing in commodity products such as gold, oil, wheat, rice, etc. passively. They have a lower correlation with the equity market and thus during a market downturn, provide protection to the investment portfolio. This is also a less expensive method to invest in commodities without buying and storing them physically.
Leveraged ETFs: This ETF can be a little technical to understand. Leveraged ETFs are constructed to get multiplying returns over the underlying assets. For example, a leveraged ETF is based on a gold index and the aim of this ETF is to get a 2X return. So if there is an upward move by 10 points in gold, the return on leveraged ETF would be 20 points.
Inverse ETFs: Inverse ETFs are based on the concept of short trading. Short trading refers to selling a stock first when the price is high and buying it back when the price falls. Thus, inverse ETFs tend to be positive when the market is down because they are a bet against the market fall.
What to consider before investing in ETFs?
There are a few factors that you as an investor should consider before investing in ETFs as mentioned below.
- Expense ratio: This is the total cost investors pay for investing in an ETF. It is a kind of fee you pay to the fund manager for investing in an ETF.
- Past performance: How an ETF has performed in the past can provide a great idea to investors of how the potential returns would be. History doesn’t always repeat but analyzing past performance can be a good measure of the expected returns.
- Trading volume: Trading volume suggests the popularity of the fund over a period of time. It is better to choose an ETF with a higher trading volume.
- Commissions: Typically, apart from the expense ratio, investors do not need to pay additional charges. Thus, this becomes a crucial factor to consider for investing in ETFs.
- Where an ETF is invested: The sector, industry, underlying assets, etc. are the significant deal breakers for investors to ponder upon. As an investor, you should ensure that you invest only in ETFs that align with your goals. For example, if you are not comfortable investing heavily in equity, there is no point in including only equity ETFs; you can go for ETFs that mix equity and debt instruments for minimizing the risk exposure.
What are the advantages and disadvantages of ETFs?
Advantages:
- Diversification: ETFs include a pool of assets and thus overweighs investing in individual assets, providing the benefit of diversification.
- Lower costs: Investors can get better rates by investing in ETFs compared to mutual funds because there are no entry or exit loads, or fees for managing the funds.
- Ease of liquidity: Because ETFs are traded on exchanges in real-time, investors have the luxury to liquidate their investment at any time as per their requirements.
Disadvantages:
- Concentrated ETFs and lack of diversification: If the ETF selected is very focused on a single security, investors may not benefit from diversification.
- Demat-based brokerage transactions: ETFs are traded on exchanges and thus need to be bought via a Demat account and brokerage charges also apply.
- Risky investment: While ETFs provide better returns, compared to fixed income instruments such as bonds, and FDs, they are risky in nature.
How much return can you expect by investing in ETFs: Is it better than investing in equity stocks?
The returns on ETF vary depending on the underlying assets. However, the average return can be anywhere between 10 to 12 percent annually. The return on investing in stocks has an average of 12 to 14 percent annually. It leads us to the question of whether investors should go for ETFs or individual stocks.
The answer depends on the expertise and knowledge of investors. For novice investors, gaining and maintaining returns are crucial, thus ETFs are a sound option. While for experienced investors, individual stocks may work better because they know when to enter and exit. In the end, the decision depends on the goals and preferences of investors.
Conclusion
ETFs are a great investment instrument to get the benefit of mutual funds and stocks. They are spread across a variety of securities and prove a great means for diversification. Unlike mutual funds, they do not consist of management fees, however, the expense ratio does apply to ETFs. Because ETFs are traded on exchanges, they are easy to trade and liquidate as per the requirements.
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