What are Exchange Traded Funds? Types and Benefits of ETFs

For the longest time, equity investments meant direct stock investing. Then came along mutual funds and investors realized they could invest in equities even if they don’t have the time, inclination, or ability to undertake research.

It wasn’t surprising, then, that the next big evolution in investing borrowed from both these concepts, effectively giving investors the best of both worlds.

We’re talking about exchange-traded funds (ETFs), the investing vehicle that has been soaring in popularity over the past few years, and with good reason.

If you are new to the world of ETFs, strap in. Because this piece will tell you everything you need to know about them.

What are ETFs?

An Exchange-Traded Fund (ETF) is a pooled investment security that invests in various financial assets, just like a mutual fund.

But they differ from a mutual fund in one important way: an ETF is listed on the stock exchange and can be traded like any stock.

What this means is when you buy mutual fund units, you buy them from a mutual fund company, and when you sell them, you sell them back to the company.

Whereas when you buy units of an ETF, you do it from the stock exchange (from another investor) and sell on the exchange as well.

Like mutual fund schemes, mutual fund companies issue units of an ETF through a new fund offer where investors buy initially buy them directly from the company. After that, shares are bought and sold on the market.

So that’s the technical difference in terms of the structure.

Now, let’s look at the other differences.

The rise of passive or index investing

The rise of ETFs coincided with another trend in investing.

Over time, as information became more available in the market, investors realized that they were better off holding broad diversified portfolios — much like indices – rather than go after concentrated, individual stock ideas.

Even mutual fund managers, who invest on investors’ behalf based on their research and expertise, started finding it difficult to beat indices. Consider this: according to S&P Indices Versus Active Funds (SPIVA), a report that tracks performance of active mutual funds, 89.1% of active Indian large-cap mutual funds failed to beat their benchmark indices over the past five-year period.

This phenomenon of disappearing ‘alpha’ (or excess returns over the benchmark) gave rise to index investing, where investors decided they would take exposure in broad market exposure instead of direct stock investments.

John Bogle, a pioneer of index investing, once said, “Don’t look for the needle in the haystack. Just buy the haystack.”

So how does the above learning apply to ETFs?

ETFs and index investing

An ETF invests in indices. Such indices could hold anything: a diversified basket of a number of stocks or they could hold thematic instruments such as stocks of a particular sector, or even bonds, commodities, currencies, and others.

So, when you buy units of say the Nifty ETF, you get exposure to the shares or units of the underlying index’s portfolio. Unlike an index mutual fund, ETFs do not aim to outperform or beat their underlying index. Instead, their target is to mirror the performance of that index.

Since ETFs are tradable securities that can be bought and sold during trading hours, as you can do with a regular stock. Their price changes throughout the day according to the market movement. This value at which ETFs are traded on the stock exchange depends upon the net asset value of the underlying index the fund represents.

You can hold ETFs for the long term as well as the short term. They have a ticker symbol like a stock. Their intraday price data can be assessed on the stock exchange during a trading day.

Since ETFs typically tend to be passive instruments (those which try to track the index’s performance), the fund manager does not play an active role but only makes periodic adjustments to mimic the benchmark index.

A timeline on the growth of ETFs

The first ETF was the SPDR S&P 500 ETF (SPY). It tracks the S&P 500 Index.

Indian investors are getting attracted towards ETFs recently. This can be said based on the fact that earlier this month, ETFs in India achieved a new milestone with 150 ETFs listed on the National Stock Exchange (NSE). The journey to the listing of the 150th ETF on the NSE took more than 20 years.

The last one-year period has seen a lot of activity in the ETF space, with 41 ETFs getting listed on NSE. The total assets under management (AUM) of ETFs in India at the end of October 2022 stood at Rs 5.02 lakh crore, witnessing around 7.7 times increase in five years.

Furthermore, ETF trading in the secondary market has witnessed exponential growth. The daily average turnover has increased by 10 times in 10 years to Rs 471 crore in the current financial year from Rs 46 crore in FY2014.

Check out the history of ETFs in India:

Some of the many categories of ETFs are Index ETFs, Equity ETFs, Debt ETFs, Gold ETFs, among others. There are International ETFs as well, that track the global indices or other international asset classes. Let us know more about these various types of ETFs.

Types of ETFs

Check out some common types of Exchange-Traded Funds (ETFs):

Index ETFs

These are very common in all ETF offerings. Index ETFs track a particular stock market index such as Sensex, Nifty, Nifty Smallcap 100, BSE 100, etc. Index ETFs are designed to invest in a basket of stocks that replicate the underlying index the ETF tracks. They aim to mirror the performance of the index and not beat their returns.

The assets under management (AUM) of Nifty 50 index-based ETFs crossed Rs 2 lakh crore mark in April 2022. This AUM increased from Rs 1 lakh crore to Rs 2 lakh crore in a span of just 20 months. As per NSE, the Nifty 50 index-linked passive funds account for 40% share of total passive funds (ETFs and Index Funds) AUM in India.

Sector or industry ETFs

Sector or industry ETFs provide exposure to a particular sector or industry, such as technology, oil & gas, or automobile. These ETFs track the performance of the companies operating in a particular sector.

Commodity ETFs

Commodity ETFs track the price of a commodity. For instance, Gold ETFs track the price of gold in the market. They have the same value as that pure 24-carat physical gold. Gold ETF units are also traded on the stock exchange. Hence, it is a unique way to invest in bullion and other commodities and earn returns.

Fixed Income ETFs

These types of ETFs provide investors with exposure to a basket of fixed-income securities in order to reduce risks and boost returns. These include bonds – Government securities, corporate or municipal bonds, etc.

International ETFs

International ETFs are a good investment option to diversify your investments into foreign securities. They track global markets or a country-specific benchmark index, thereby widening your market exposure globally.

Benefits of ETFs

  • ETFs offer a diversified pool of securities and provide investment channels across different asset classes. This helps in diluting risk significantly.
  • As ETFs are tradable securities, they can be bought and sold anytime during market hours if there are any changes in their value. This enables investors to have flexibility in their choices of investments.
  • Moreover, ETFs generally command lower fees than mutual funds. Being a passive fund, the administrative costs are lower than actively managed funds. The expense ratio for an ETF is also low, leading to higher returns. It can be as low as 0.25%. This cost-efficient nature makes them attractive among retail investors.
  • Gains from ETFs are liable for capital gains tax and dividend taxes. However, if compared to mutual funds, the amount of fee charged is much lower in ETFs.
  • The investing community can begin their investment journey through ETFs as they are simple instruments in the capital market and are available on multiple themes within each asset class or in a combination of asset classes. ETFs provide an array of choices catering to investors’ diverse needs and risk appetite.
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