What Are Exchange-Traded Funds?

If you have been investing in mutual funds, you may have come across the term ETFs. ETF stands for Exchange-Traded Funds, which is a pooled investment fund. In the recent past, ETFs have become a popular investment instrument for all types of investors. 

 

This is evident from the fact that ETFs have more than doubled in the last three years, i.e., from 84 to 171 between March 2020 and March 2023. While ETFs share many similarities with mutual funds, these low-cost investment tools also come with unique structures and investment strategies. 

Read on for answers to the question, “What is an ETF?”, and to learn how they work.

ETFs are a type of mutual fund that is passively managed. These funds track publicly available indices like BSE Sensex or NSE Nifty and try to replicate their performance. 

 

These are basically index funds, the units of which can be traded in stock markets. Unlike index Funds, the value of the ETFs fluctuates throughout the trading day. On the other hand, the value of index funds is determined based on the NAV at the close of the trading day.

You can choose between the following types of exchange-traded funds where you can hold your money:

• Index ETFs: These funds invest in company stocks with the aim of replicating the performance of an index

• Gold and Silver ETFs: These funds allow investors to invest in gold and silver bullion without having to purchase these commodities in physical form 

• ETFs with International Exposure: These funds are based on overseas stock indices and allow investors to access foreign stock markets

 

Fixed Income ETFs: These funds invest primarily in every bond-type available

The following are perks associated with ETF investing:

• Easy and Convenient Trading: Like stocks, you can trade in ETFs throughout the trading day, a facility that is not available with mutual funds

• Flexibility in Trading: As mentioned above, these funds are traded in stock markets, which means that you place different order types like limit or stop-loss orders

• Transparency: Most of the ETFs are required to report their holdings, which ensures a higher level of transparency

• Tax Efficiency: As these funds offer less capital gains and appreciation, they are more tax-efficient as compared to actively managed mutual funds

Before you decide to park your funds in ETF Funds, it is crucial for you to know about the investment risks involved. 

 

The following are some of the risks associated with investing in Exchange-Traded Funds:

• Higher Trading Cost for Modest Investments: If you invest small amounts, the total cost of investing would be higher than a no-load fund, which deals directly with a fund company

• Low Liquidity Levels: ETFs, which are not traded in high volumes, generally have higher bids or ask spreads, making them illiquid or difficult to sell

• Technical Challenges: Variances may occur in ETFs’ performance due to technical errors in tracking a publicly available index

• Settlement Time: When you buy or sell an ETF, it usually takes two trading days to get your transaction settled and reflect in your Demat account

 

In conclusion, an exchange-traded fund may be the right investment instrument for you. This is because it allows you to invest in a large basket of securities at low-cost administrative costs. 

 

These investments are generally tax-efficient and cost you less compared to mutual funds. Not just that, these funds also offer a higher degree of diversity. On the other hand, there are various high-risk ETFs available in the market offering higher returns.

 

Hence, it is crucial for investors to consider their financial goal, risk tolerance, performance of the funds, associated administrative costs, etc., before investing in these funds.