Exchange Traded Funds (ETF) – Meaning, Benefits, Comparison

In the rapidly evolving landscape of mutual funds, Exchange-Traded Funds (ETFs) have emerged as one of the most compelling investment options.

The growth of ETFs in India has been phenomenal, with assets under management (AUM) growing from ₹23,000 crore in 2016 to ₹6.64 lakh crore by March 2024, reflecting growing recognition among investors of the benefits that ETFs offer, including diversification, cost-efficiency, and ease of access to a wide range of markets and sectors.

With active large-cap mutual funds consistently underperforming large-cap indices like the Nifty 50 and Sensex, ETFs have emerged as a popular choice for investors looking for a balanced, flexible, and transparent investment option with the lowest expense ratios.

This guide is designed to help you understand the essentials of ETFs, explore their benefits, and provide a clear understanding of how they work.

What is an ETF in the Stock Market?

An ETF is an investment fund that trades on stock exchanges like individual stocks, allowing investors to buy and sell at market prices throughout the business day. This is in contrast to mutual funds, where prices are quoted at the end of the business day.

ETFs inherently promote diversification by holding a basket of securities across multiple sectors, which helps reduce the impact of poor performance or volatility in any single holding on the overall portfolio.

ETFs track a specific index (like the Nifty 50 or NASDAQ), a sector (like technology or healthcare), or even a commodity (like gold or oil). The idea is to replicate the performance of a particular index or asset, offering investors a way to invest in a wide array of assets with a single purchase.

How ETFs Work: The Mechanics Behind the Scenes

Understanding how ETFs work can help demystify their appeal. Here’s a simple breakdown:

• Creation and Redemption: The process starts with the “creation and redemption” mechanism, where authorized participants (typically large financial institutions) create ETF shares by purchasing a basket of underlying securities. These shares are then sold on the stock exchange. To reduce the supply, institutions can redeem ETF shares by selling the underlying securities.
• Trading on Exchanges: Once the ETF shares are created, they are traded on the stock exchange just like any other stock. This means investors can buy and sell ETF shares at any time during market hours at the prevailing market price.
• Tracking the Index: Most ETFs are designed to track the performance of a specific index. For example, an ETF that tracks the Nifty 50 will hold all the stocks in the Nifty 50 index in the same proportion as the index itself. The goal is to replicate the index’s performance as closely as possible.

Benefits of Investing in ETFs

Investing in ETFs offers several compelling advantages, especially for those new to the investment world. Some of the benefits are:

• Diversification: One of the most significant benefits of ETFs is the ability to diversify your investment across a wide range of assets. By holding an ETF, you are essentially investing in a portfolio of assets rather than a single security. This helps investors spread risk across asset classes, thereby reducing the impact of underperformance in a single asset.
• Cost-effective: ETFs tend to have the lowest expense ratios compared to mutual funds. Since they are passively managed, tracking an index rather than actively trying to beat the market, the management fees are generally lower. This makes ETFs a cost-effective investment option for mutual fund investors looking to minimize expense ratios.
• Flexibility and Liquidity: ETFs can be bought and sold at any time during market hours, providing investors with flexibility that mutual funds, which are traded only at the end of the day at Net Asset Value (NAV), do not offer. This liquidity means that you can react quickly to market changes and make timely investment decisions.
• Transparency: ETFs are known for their transparency. The holdings of an ETF are usually disclosed daily, allowing investors to know exactly what they are investing in. This is in contrast to mutual funds, which typically disclose their holdings twice a year, in March and September.
• Tax Efficiency: The unique structure of ETFs, where units are created and redeemed in large blocks, helps minimize capital gains distributions, resulting in lower tax liabilities for investors. This makes ETFs more tax-efficient than mutual funds.
• Accessibility: With ETFs, even small investors can gain access to a wide range of markets and asset classes that might otherwise be out of reach. Whether you want to invest in international markets, specific sectors, or even commodities, there’s likely an ETF that fits your needs.

ETF vs. Mutual Fund: A Comparative Analysis

When considering investment options, beginners often find themselves comparing ETFs with mutual funds. While both offer a way to invest in a diversified portfolio, there are key differences to keep in mind:

• Management Style: Most ETFs are passively managed, meaning they aim to replicate the performance of an index. Mutual funds, on the other hand, can be actively managed, where fund managers attempt to outperform the market. While active management can potentially offer higher returns, it also comes with higher fees. Even actively managed funds do not guarantee outperformance, as they may lag behind the benchmark.
• Trading Flexibility: ETFs are traded on stock exchanges, allowing investors to buy and sell shares throughout the trading day, whereas mutual funds are bought and sold at the net asset value (NAV) at the end of the trading day. This means ETFs offer more flexibility in terms of timing your trades.
• Costs: As mentioned earlier, ETFs generally have the lowest expense ratios compared to mutual funds. The passively managed nature of most ETFs contributes to this cost advantage. However, it’s important to note that investors in ETFs may incur trading commissions, though these have become less common with the rise of commission-free trading.
• Tax Implications: ETFs tend to be more tax-efficient than mutual funds because their “in-kind” creation and redemption process reduces capital gains distributions, thereby lowering potential tax liabilities for investors. On the other hand, mutual funds often generate higher capital gains from frequent buying and selling, which are passed on to investors, potentially increasing their tax obligations.
• Minimum Investment: Mutual funds often require a minimum investment, which can be a barrier for some investors. ETFs, on the other hand, can be purchased in small quantities, making them accessible to a wider range of investors.

How to Buy ETFs: A Step-by-Step Guide

If you’re convinced that ETFs might be a good fit for your investment strategy, you’re probably wondering how to get started. Here’s a simple guide on how to buy ETFs:

• Open a Demat and Trading Account: To buy ETFs, you’ll need a Demat and trading account with a brokerage that offers access to the stock exchange. This account will allow you to hold and trade ETF shares.
• Choose the Right ETF: With so many options available, it’s important to choose an right ETF that aligns with your investment goals. Consider factors like the ETF’s underlying assets, expense ratio, and past performance. For beginners, it’s often recommended to start with broad-based ETFs that track well-known indices like the Nifty 50 or the S&P 500.
• Place Your Order: You can place an order through your brokerage account after selecting an ETF. You’ll need to specify the number of shares you want to buy and the type of order (market order, limit order, etc.). The trade will be executed during market hours, and the ETF shares will be credited to your Demat account.

Best ETFs in India: Where to Start?

If you’re looking to invest in ETFs in India, here are a few of the top-performing ETFs to consider:

• Nippon India ETF Nifty BeES: One of the oldest and most popular ETFs in India, this ETF tracks the Nifty 50 Index and offers exposure to the top 50 companies listed on the NSE.
• SBI ETF Nifty 50: Another solid option for those looking to invest in the Nifty 50, this ETF is known for its low expense ratio and strong liquidity.
• HDFC Sensex ETF: This ETF tracks the S&P BSE Sensex, giving investors exposure to 30 of the largest and most actively traded companies in India.
• ICICI Prudential Gold ETF: For those interested in commodities, this ETF offers exposure to gold, allowing investors to benefit from the performance of the precious metal without having to physically own it.

Disclaimer – This article provides general information and is not intended as a substitute for professional financial advice. Please consult with a qualified financial advisor before making any investment choices.

Conclusion: Is Investing in ETFs Right for You?

ETFs have revolutionized the investment landscape by offering a flexible, cost-effective, and transparent way to gain exposure to a wide range of assets. Whether you’re a beginner looking to dip your toes into the stock market or a seasoned investor seeking to diversify your portfolio, ETFs can be an excellent addition to your investment strategy.

Before making any investment decisions, it’s crucial to do your research and understand the risks involved. If you’re interested in learning more about ETFs and other investment options, MutualFundWala offers a wealth of resources to help you make informed decisions.

Visit MutualFundWala today to explore our expert reviews and stay ahead of the curve in your financial journey.