What is an ETF in the Stock Market: All investors need to know
As the name suggests, ETFs or Exchange Traded Funds are traded directly on the exchange throughout the day and it includes index-based products that do not require active management, you can buy and sell ETFs any time you want during the market hour. Exchange traded funds pool money from investors just like mutual funds and use it to purchase assets such as stocks, bonds, and derivatives. A beginner in the stock market having limited expertise about it can opt for investing in ETFs.
What is ETF fund?
In simple words, ETF funds can be described as a marketable security that tracks an index, a basket of assets like an index fund, bonds, or commodities, and these ETF funds are traded on stock exchanges like common stock.
How do ETFs work?
ETFs stand for Exchange traded funds and can be traded directly on the stock exchange and it offers investors to invest in a fund that replicates the performance of a basket of stocks ( generally an index). One can invest in ETFs by buying units directly from the stock exchange during the trading time and like equity stocks, they have tickers (e.g., SPY). ETFs are listed on important stock exchanges and the price is determined by demand and supply just like stocks. Hence, the price keeps on changing during the market hour based on the change in the price of underlying assets.
Investors are provided adequate liquidity and also fair prices while investing in ETFs. Since ETFs are traded directly on stock exchanges, you need a Demat account to buy ETFs.
Therefore, ETFs can be bought and sold during market hours of the stock exchange just like equity stocks but ETFs do not offer intraday buying or selling to investors. Investors can opt for buying ETFs for better diversification of their holdings.
Evaluating and Investing in ETFs
When considering investing in ETFs, it's essential to evaluate them based on your investment goals, risk tolerance, and investment horizon. Here are some steps to get started:
a. Define Your Investment Goals: Clarify what you want to achieve with your investment, such as long-term growth, income generation, or diversification.
b. Research and Select an ETF: Conduct thorough research to identify ETFs that align with your investment objectives. Consider factors like the ETF's expense ratio, tracking error, liquidity, and the underlying index it tracks.
c. Open an Investment Account: To invest in ETFs, you'll need to open an investment account with a brokerage firm. Compare different brokerage options and choose one that meets your requirements.
d. Place an Order: Once your account is set up and funded, you can place an order to buy shares of the chosen ETF through your brokerage platform. Determine the quantity of shares you wish to purchase based on your investment strategy and available funds.
e. Monitor and Review: Regularly monitor the performance of your ETF investments. Periodically review your portfolio and consider rebalancing if necessary to maintain your desired asset allocation.
Benefits of investing in ETFs
- Diversification: Investing in ETFs allows you to diversify your portfolio efficiently, without worrying about selecting individual stocks or bonds. Most ETFs cover major asset classes and sectors, providing you with a broad selection. ETFs like regional ETFs, international ETFs, or specific industry ETFs allow you to access sectors that you may find difficult to invest in. diversification in different asset classes minimizes the risk of your portfolio because when one asset underperforms in an ETF, other assets will compensate by growing exponentially.
- Low Cost: Most ETFs are less expensive than mutual funds and that makes them a low-cost investment option. Mutual funds charge entry and exit load, expense ratio, management fees, etc whereas ETFs charge comparatively lower expense ratios than mutual funds.
- Tax-efficient: ETFs are tax-friendly due to lower turnover and redemption process. ETFs charge comparatively lower fees than mutual funds because the capital gains and income from the ETFs are lower.
- Passive management: The objective of ETFs is to replicate the market and the fund manager only needs to make occasional changes to match a market index and as they are passively managed, they are less riskier than mutual funds.
- Liquidity: ETFs are traded on stock exchanges like any other stock and any change in the value of an ETF can be noticed instantly and can be traded throughout the market hour of the day. Therefore, ETFs have more liquidity than mutual funds and more liquidity enables you to have a variety of choices to invest with ease.
Potential Risks of ETFs
While ETFs have their advantages, it's important to be aware of the potential risks involved. Understanding these risks can help you make informed investment decisions. Let's explore some key risks associated with ETF investing:
a. Market Risk: ETFs are not immune to market fluctuations. If the underlying assets within the ETF experience a decline in value, the ETF's share price will also be affected.
b. Tracking Error: Some ETFs may not perfectly replicate the performance of their underlying index due to factors like fees, trading costs, or sampling methods. This discrepancy is known as tracking error and can impact the returns of the ETF compared to the index it tracks.
c. Liquidity Risk: While most ETFs are highly liquid, certain niche or specialized ETFs may have lower trading volumes. This can result in wider bid-ask spreads, making it more challenging to buy or sell shares at favorable prices.
Difference between ETFs and Mutual funds
| ETFs | Mutual Funds |
| Exchange-traded funds can be bought and sold during the market hour of a trading day | Mutual funds can be bought or sold at the closing net asset value.
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| ETFs have fewer operating expenses | Mutual fund operating expenses vary from fund to fund.
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| ETFs do not provide any minimum investment option | Mutual funds have minimum investment options available for investors having a low budget.
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| ETFs track an index by assembling a portfolio that should match the index constituents | Mutual funds are actively managed by fund managers and assets are chosen in such a way that they should beat the benchmark index.
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| ETFs do not have limitations on time to sell an asset as they can buy or sell anytime during the market hour | Mutual funds may charge a penalty if you sell the share early.
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Conclusion
Exchange-Traded Funds (ETFs) have revolutionized the way investors approach diversification, cost-efficiency, and flexibility in their portfolios. With their broad range of benefits, including diversification, lower costs, liquidity, and investment flexibility, ETFs have become a popular choice among investors of all levels of expertise.
However, it's crucial to remember that investing always carries risks. Stay informed about the potential risks associated with ETFs, such as market fluctuations, tracking error, and liquidity risks. By understanding the basics of ETFs and conducting thorough research, you'll be well-equipped to make informed investment decisions that align with your financial goals.
Remember, personalized financial advice from a qualified professional can provide valuable insights tailored to your specific situation and investment objectives.
Are ETFs good for beginners to invest in?
ETFs are a great way to start investing in the stock market as they are comparatively inexpensive, available through traditional brokerages, and are less risky than investing in an individual stock.
How do ETFs vary from mutual funds?
One key difference between ETFs and mutual funds is that most ETFs are index funds while mutual funds require an active strategy that enables them to outperform the market index.
Why are ETFs admired by investors?
ETFs have been around for almost 25 years, they have become popular in the past five years because of low cost investing.
Are ETFs less expensive than mutual funds?
No, ETFs are not necessarily cheaper than index mutual funds.
What are ETFs in India?
In India, mostly ETFs are registered with the Securities and exchange board of India (SEBI) and it includes a basket of stocks (Indices) that can be traded on the stock exchanges.