What are ETFs?
Exchange-Traded Funds or ETFs are an innovative way to invest. They have become popular globally ever since their launch in the USA in 1993. ETFs follow the mutual fund model wherein multiple investors pool their funds. A fund manager will invest these funds for them. ETFs can include different investments such as stocks, bonds, currencies, and commodities. It can contain thousands of stocks from various industries or can be limited to a specific sector or industry. However, unlike mutual funds, Exchange Traded Funds are listed and traded in stock exchanges. Like other stocks, ETFs have buyers and sellers, and forces of demand and supply determine their prices.
What are ETFs in India?
In India, Exchange Traded Funds have become the most common way for passive investing. This is mainly because mutual funds in India have a higher expense ratio than ETFs. While the expense ratio for mutual funds lies between 1.05 and 2.25%, the ETF expense ratio is less than 1%.
ETFs also offer flexibility. Instead of randomly investing in a few stocks of your choice, you can opt for more diversification. You can also buy and sell ETFs anytime the market is open based on the price at a particular point in time.
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What are the Major Differences between Index Funds and Exchange Traded Funds?
Index funds are portfolios of bonds and stocks generated specifically to mimic the composition and performance of a financial market index. It is also a great passive investment strategy like the Exchange-traded funds. However, it is easy to get confused between index funds and Exchange-traded funds because both track indices and allow portfolio diversification at a lower cost.
The following table highlights all the key differences between ETFs and Index Funds:
| Factors | EXCHANGE TRADED FUNDS | INDEX FUNDS |
| Definition | An ETF is a collection of securities that usually tracks a particular set of equities and is traded just like a stock in an exchange. | An index fund is a collection of securities that tracks and analyses the performance of a particular market index to replicate its proportions. |
| Model Structure | The ETF model is similar to Mutual funds and contains stocks that compose indices such as Sensex or Nifty. It follows two main structures, namely physical and synthetic ETFs. While Physical ETFs tend to follow the results of a market index by either holding all or a sample representing the index’s underlying constituents. Synthetic ETFs replicate the index’s performance using derivatives and swaps rather than physical securities. | The index fund model is all about mimicking stock market insides. Compared to an ETF, it contains more assets in cash or liquid securities. This makes index funds susceptible to tracking error and can cause them to divulge from the returns on the actual indices. |
| Expense Ratio | ETFs have an expense ratio that is less than 1%. However, investors also need to pay a Demat account maintenance charge of 1%. | Typically, index funds have a lower expense ratio than ETFs as they can go as low as 0.1% to 0.05%. Investors also need to pay a fixed transaction fee of Rs.100 when the investment crosses Rs.10,000, in addition to the expense ratio. |
| Main Benefit | ETFs offer flexibility in terms of investment diversity and trading. Investors can trade ETFs on a very short or long term basis. | Index funds have low flexibility as they do not allow for diversification and are suitable for those looking into long term investments. |
| Flexibility | ETFs offer flexibility in terms of investment diversity and trading. Investors can trade ETFs on a very short or long term basis. | Index funds have low flexibility as they do not allow for diversification and are suitable for those looking into long term investments. |
What are the types of Exchange Traded Funds?
Not all ETFs are the same. There are many types of ETFs available for investors, and each type has a different purpose. While one can be great for income generation, others can help partly offset or even hedge the risk in the investor’s portfolio.
ETFs can be broadly classified into the below 5 types:
- Bond ETFs: Many Bond ETFs are available for investors, from international and domestic government bonds to corporate bonds. Usually, bonds are not that liquid and are held to maturity. However, Bond ETFs can be traded actively in markets. They are great for investors who want to gain exposure to the bond market. Bond ETFs can be broad or specific. While broad-market ETFs tend to cover the entire market, there are specific types of bond ETFs such as corporate debt, treasury bonds, etc.
- Commodity ETFs: In India, you can find commodity ETFs target specific areas or areas of the market. Commodity ETFs are attractive because, without having to learn how to buy futures or other forms of derivative products, investors get exposure to commodities. These ETFs focus on one commodity by keeping it in physical storage or investing in futures contracts. These ETFs are great for investors looking into diversifying their portfolios across asset classes. However, to avoid traps, the investor must be aware of the future market.
- Currency ETFs: In India, you can find currency ETFs are similar to commodity ETFs. With commodity ETFs the investor profits from buying shares representing a physical commodity instead of directly owning it. With currency ETFs, they profit from the shifts in foreign currency values against the U.S. dollar value. Currency ETFs contain shares that represent a specific amount of a foreign currency. These ETFs are great for investors trying to gain foreign exposure. However, it is essential to note that currency investments should be a smart part of your investment strategy because currencies are becoming more volatile.
- Sector ETFs: As the name suggests, Sectors ETFs allow investors to buy stocks from a particular sector in the market. Instead of investing in all industries in small fractions, Sector ETFs enable investors to focus on a specific sector. Sector ETFs can prove to be highly beneficial if the sector that you have chosen is doing particularly well. For instance, during the Covid-19 pandemic, the Pharma industry has become lucrative for investors. However, it is a high-risk investment as you pool all your funds and invest it in one sector.
- Gold ETFs: Investing in gold has always been a great way to hedge against fluctuations in the economy and currency. However, investing in physical gold comes with certain taxation, resale, quality, and resale issues. A gold ETF focuses on tracking the price of actual physical gold and allows you to purchase an electronic form of gold. It is also a synthetic ETF like the commodity ETF. One Gold ETF represents an investment in 1 gram of physical gold of the purest quality. Like other stocks, Gold ETFs are traded on Bombay Stock Exchange Ltd. (BSE) and the National Stock Exchange of India (NSE).
Are there ETFs available for every asset class?
The simple answer to this question is yes. Exchange-Traded Funds are available for all the possible asset classes, from traditional asset classes such as cash, stocks and bonds to alternative asset classes such as currencies and commodities. The above list specifying the different types of ETFs showcases this.
Will all ETF prices fall if the stock market does?
Since ETFs are available for all asset classes listed in the stock market, there is a chance that the ETF prices will fall when the stock market does. However, they are more likely to return to the prices equivalent to the value of the underlying assets in the market.
Some investors prefer to invest more in Exchange Traded Funds when the market falls as the cost of investments becomes relatively low in such scenarios, and returns will increase after the market recovers. However, this requires a deep understanding of the stock market and the willingness to take high risks.
ETFs are certainly not risk-free, which is why you need to consult a financial advisor who is not only an expert in investing but also understands all the risks that are associated with ETFs.
At WealthDesk, we allow investors to pool their funds into a specific WealthBasket of equities. Our experts study the stock market and research to create well balanced and diversified ETF portfolios. These portfolios are then turned into WealthBaskets, which can be integrated with your broking accounts. Once you choose WealthBaskets, advisors keep updating them to maintain your target risk vs return expectations.
Can ETFs be active?
As the Exchange Traded Funds market has evolved, different ETFs have emerged. There are two types of actively managed ETFs: the traditional actively managed ETF, while the other is the recently approved semi-transparent active ETFs.
The main concept behind active management is that the portfolio manager will try to modify the fund investments as required without following the rules of tracking an index. In other words, the portfolio manager or a team makes all the decisions on the underlying portfolio allocation without following the typical passive investment strategy.
Though actively managed ETFs have a benchmark index, the portfolio managers will have the bandwidth to alter market-time trades sector allocations. They can even deviate from the index as they see fit.
Unlike traditional ETFs, investors will not be able to predict the portfolio’s future composition, which can be helpful when the market conditions are highly volatile. The portfolio manager can shift fund allocations from underperforming asset classes to better asset classes or sectors.
In India, there are certain regulations regarding actively managed ETFs. The portfolio managers must follow an index published by index providers such as MSCI. The latter conduct quantitative research on the financial statements of various companies listed in the stock market.
In conclusion, Exchange Traded Funds are great for beginner investors trying to gain some exposure to the stock market. We hope this ETF investment guide has helped you understand all about ETF investment in India. You may look at this the complete guide to ETF portfolio management.
Check out the ETF-based WealthBaskets curated by the top Indian financial institutions and create a diversified portfolio for better returns. Happy investing!
FAQS
In India, you can invest in ETFs during market hours. All you need to do is log in to your Demat account and search for the ETF you want to invest in. You can find ETFs for various sectors and strategies.
ETFs are a good tool for investors looking to diversify their portfolios. As compared to direct equity investments, ETFs provide a much higher level of diversification which in turn leads to lower risk. ETFs are also more liquid than mutual funds as they can be traded on the exchanges.
An investor can sell ETFs during market hours. As compared to mutual funds which can only be sold after market hours and only to the fund manager, ETFs provide better liquidity.
It is possible to build a core long term portfolio with just ETFs. You can learn about the 3 ETF strategy from this blog.
Dividend paying ETFs do exists in India. These dividends may be paid at a certain interval, depending on the ETF.
