Investing in funds is still not common among most new investors. A lot of retail investors flock to stocks and Fixed Deposits to start investing in. In this article, we look at what are Exchange Traded Funds, benefits of ETFs and how beginners can start investing in Exchange Traded Funds.
What are Exchange Traded Funds?
Just as the name says, Exchange-Traded Funds are the funds that are traded openly on an exchange just like stocks. ETFs are very much similar to stocks when it comes to being traded in open market and their liquidity. Then again, ETFs are similar to Mutual Funds when it comes to fund management, diversity and growth opportunity.
For a new investor who is not experienced in picking the best of stocks, buying ETF shares makes a lot of sense. These are relatively cheap and helps in diversifying the portfolio. Multiple features help beginners to invest because of the flexibility.
Features of Exchange-Traded Funds
Exchange Traded Funds has been popular among investors for their versatile features as these offer the best of both worlds when compared with investing in Stocks and Mutual Funds
Unlike Mutual Funds that are traded once per day after the market closes, ETFs are bought and sold while the market place is open. This is an important factor when volatility is high. It offers you a large window to trade and take up a position or close a position based on market news.
Almost all the ETFs are registered under the Securities and Exchange Board in India (SEBI) which gives the investors the confidence that their investment in the right marketplace.
ETFs are mostly a mixture of the features of Mutual Funds and stocks which increase the liquidity of the assets of the investors.
Since ETF is traded in the open Market similar to stocks, the market price is the deciding factor on the cost of the fund. This also means that there are more buyers and sellers for these funds that provide it greater liquidity.
ETF can be purchased in small amounts as they trade like stocks. Small positions can be purchased or a single small portion can be taken out in ETFs. On the other hand, Mutual Funds operate on Net Asset Value (NAV) which changes from day to day and is updated at the end of the trading day at midnight.
Another big difference is in the cost structures, mutual funds have expensive management fees, load fees, entry fees, exit fees etc. Exchange Traded Funds come at much lower costs. The expense ratio of exchange-traded funds are much lower than managed funds.
When compared with stocks, ETFs provide a huge advantage in terms of bringing diversity to your portfolio. ETFs can be segmented into target sectors of the economy that allows investors to have diversified positions and exposure to their preferable sectors.
You no longer will be pegged to the future of one company, instead rest assured as your portfolio gets less risky due to it’s diverse holdings.
How does Exchange Traded Funds work?
In the actively managed ETFs, the fund provider has underlying assets and designs funds for tracking the performance. They then sell shares of the fund to the investors.
Think of these as kind of mutual fund shares. In the case of mutual funds, the management and portfolio design, structure, rules and fund management practices are pretty much the same. However, you need to buy the fund from the Mutual Fund directly and sell it back to the MF directly. In the case of ETF, you can buy from the open market and sell back to open market.
Any individual investor can buy or sell an ETF as needed during the equity trading time.
An ETF provider has multiple assets including stocks, bonds, bonds, commodities, and currencies, and creates a unique ticker. Investors buy a share of that collection of assets.
When the price of one or more asset rises, the share price of the ETF rises accordingly. Most ETF tracks a specific index and trade very close to the net value of the assets.
How to invest in ETF?
ETF doesn’t have a pre-assigned investment amount. You will require to open a brokerage account before you purchase or invest in ETFs. In online brokerage, most of the brokers now provide commission-free stock and ETF trade which reduces the cost factor.
Then you have to choose your first ETFs and index ETFs are some of the best for beginners as they are cheaper than the counteractive part. ETFs are designed as a maintenance-free or next to nil maintenance. Once you have invested, let the ETF do its work.
Patience is a key to investments in ETFs, especially for beginners. You will not see drastic movement or increase/decrease in value similar to stocks. This is due to the diverse portfolio. Over a period of time as the sector grows, your investment too grows with it. As a beginner investor, you should just wait and watch the excellent investment growth over time.
ETF vs Mutual Funds
In most aspects, ETFs and Mutual Funds are very similar. There difference comes in few areas:
Where they are traded
ETFs are traded in the open market. You can buy and sell from other individual or corporate investors. In the case of MFs, you buy from the Mutual Fund house and sell back to them.
Cost between ETF and Mutual Funds
ETFs have much lower expense ratio. Most of the ETFs are non-maintenance and do not require you to pay a fee annually. There is no entry or exit fees. Mutual funds on the other hand are more expensive due to their structure and direct selling approach.
ETFs are traded on the exchange, as such trading can be done only when the exchange is open. Mutual funds are not publicly traded, as such, you can sell it when ever you wish. But, the Mutual Fund value will be calculated as of the midnight when you raised the sale request as NAVs are updated on every midnight.
Advantages of Exchange Traded Funds
- While you purchasing a share in a company, you are limited within the performance of the company itself, you are limited to the performance of the company which in return creates higher risk. In ETF you are allowed to spread your investment across a basket of companies.
- ETF can be bought and sold throughout the trading day so any changes in the value can be noticed immediately allowing you to take quick decisions.
- It has much higher liquidity than mutual funds which gives you the flexibility in making the investment. It gives the liberty to shift to other security in case expected profit is not generated.
- A small position can be purchased to scale in or scale-out of a position to adjust the sizing of position according to need.
Types Of ETF
The categories of ETFs depend on the underlying stocks or asset class that are part of the Exchange Traded Fund. Below are a few common types of ETF-
- Stock Exchange Traded Fund: Include stocks and is meant for long-term growth. The risk factor is moderate and tied to the performance of the underlying stocks.
- Commodity ETFs: The undelying asset in these funds are commodities. These can be more volatile than stocks owing to multiple contributing factors such as weather, political climate, international influence etc.
- Bond Exchange Traded Fund: Bond ETF can generate regular cash flow for the investors as they don’t have a maturity date, unlike individual bonds.
- International Exchange Traded Fund: These funds invest in foreign stocks. It is a good idea for some one who wishes to diversify their portfolio into a different geography, without having to set up foreign accounts.
- Sector ETFs: These are funds that are focused on a particular sector such as Healthcare or Technology and only invest in related stocks/assets.
- Gold Exchange Traded Fund: Gold ETF is used to track the physical gold price. Gold is considered a safe asset as its price are not very volatile. Gold ETF combines the flexibility of stock investment and the simplicity of gold investments.
- Debt Exchange Traded Fund: Debt ETF deals on the cash market of NSE. These can be bought and sold at a live marketplace like any other stock. Investments in debt funds are considered to be safer as there is less exposure compared to an individual stock.
- Currency Exchange Traded Fund: Currency ETF offers investors exposure to a single or a basket of currencies.
These are Equity ETF, Debt ETF and Gold ETF are the major ETFs in India.
No, we cannot exchange Mutual Funds for ETFs.
Since liquidity in ETFs are higher which reduce the risk factors, traditional ETFs are considered to be safer than stocks.
Yes, due to diverse specification and flexibility in investments and the fact that ETFs can be bough directly from the stock market, it becomes comfortable for beginners to invest.