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In 1993, Exchange-Traded Funds were introduced in the USA. Since then, they have become more well-known not just in America but also across the rest of the globe. In India, the first ETF was introduced in 2002 under the name Nifty BeEs. It has since expanded by 1914. 15% (absolute returns). Nifty BeEs follow the benchmark "Nifty" index. Mutual funds and stocks are familiar concepts to many investors. However, there is little knowledge about ETFs among investors.

We are providing you with an introduction to ETFs in this post.

What is an ETF?

An ETF is a mutual fund with a select few distinctive characteristics. Like every mutual fund, an ETF receives money from investors, has fund management, and will have a NAV (net asset value). Nevertheless, they differ from standard mutual funds in two ways, detailed below. They are:

  • Regular mutual funds are not traded on the stock exchange, but ETFs are.
  • ETFs are passive mutual funds that often follow prestigious indexes like the Sensex or the Nifty.

The fund managers of ETFs purchase equities from the indexes that serve as their benchmarks and ensure that the returns of the ETFs closely track those of the index.

ETFs are listed on stock exchanges, just like stocks are. Using their stockbrokers, investors may trade or invest in them.

Similarities Between ETFs and Mutual Funds

Among mutual funds, ETFs are one type. A fund manager will be involved in this situation as well.

This manager will combine the funds from various investors and work to keep the portfolio consistent with the fund's concept. Like index mutual funds, which are similarly structured to mirror an index's composition, ETFs may have portfolios resembling those mutual funds.

Differences Between ETFs and Mutual Funds

  • The management approach is the primary distinction between an ETF and a mutual fund. The majority of mutual funds are handled actively. This implies that the fund manager may continuously monitor and adjust the portfolio for optimum performance.
  • However, an ETF is passively managed because the fund closely follows an index. In an ETF, the fund management only makes adjustments when there is a change in the makeup of the index, as opposed to personally selecting the stocks through research.
  • Additionally, stock market trading is permitted for the units of ETFs. In contrast to mutual funds, whose units cannot be transferred to another investor, their units may be traded like stocks.

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ETFs Category

There are four types of ETFs:

1. Equity ETF: These ETFs attempt to monitor the performance of stock indexes or a collection of equities from a particular area or industry. These ETFs aim to replicate the performance of their underlying benchmark index or a specific sector.

2. ETFs with exposure to the world: Certain ETFs imitate the performance of international stock indices. They provide investors access to global markets and allow them to participate in particular economies' success stories.

3. Gold ETFs: Gold investment is a valuable technique against currency fluctuations and economic downturns. However, buying genuine gold has several disadvantages, including security, quality, resale, and taxation. Exchange-traded funds (ETFs) that invest in gold bullion give investors a way to add the metal to their portfolios without buying any physical gold.

4. Debt ETFs: Debt ETFs can be used to buy fixed-income assets. On the NSE, they are traded often. Debt mutual funds are more costly than debt exchange-traded funds.

Advantages of ETFs

A fantastic way to diversify your stock investments is using an ETF. Based on your investment portfolio, you can only purchase a limited amount of stocks when you invest in stocks. Choosing the correct stocks becomes essential as a result. However, if you invest in an ETF that tracks a sector or asset class, you have exposure to a broader range of assets, which diversifies and improves your portfolio. Here are a few benefits of ETFs:

  • Like shares, ETFs are readily tradeable on stock exchanges.
  • The market price is used to swap ETF units. You may profit if market perception favors the sector or ETF tracking market.
  • Anytime during the day is acceptable for buying and selling units.
  • An ETF's expense ratio is frequently lower than most conventional mutual funds.

Disadvantages of ETFs

Although the demand for ETFs is increasing day by day in India, it also has many disadvantages-

  1. Needs a Demat account: With other mutual fund schemes, you do not need a Demat account to invest in ETFs. Account opening fees and yearly maintenance fees are associated with a Demat account. You will also need to pay a brokerage to execute your orders for buying and selling ETFs.
  2. Minimal liquidity: For some ETFs, there is a limited trading volume. You might have to pay more than NAV when purchasing ETF units due to poor liquidity. Similarly, selling ETF units may require you to do so at a loss relative to NAV due to poor liquidity.
  3. There is no SIP investing mode: When it comes to active mutual fund schemes, systematic investment plans let you invest in them (SIPs). However, the SIP manner of investment is not available for ETFs. Every time you wish to invest in an ETF, you must use your trading account to place an order to purchase the units from the market.

[ Lookout the Right and Duties of Share Holder ]

Why is a Demat Account Required for ETFs?

To invest in ETFs, a Demat account is necessary. Your trading account allows you to place a purchase order. ETF units will be credited to your Demat account, and the transaction money will be deducted from your trading/bank account during settlement. 

You must use your trading account to submit a sell order to sell ETF units. In the settlement, the ETF units will be taken from your Demat account, and the transaction value will be deposited to your bank or trading account.

How to Invest in ETFs in India?

Exchange-traded funds ETFs are among the most well-liked passive investing products available today. India is just now seeing a rise in ETF investment. Describe the ETF. By acquiring shares of the Nifty index from the fund AMC, which is the ETF's sponsor, institutions will be able to add the ETF to their portfolio (in the case of a Nifty ETF).

Then, it is made available to individual investors in small units in the same ratios as the Nifty index constituents.

What Needs to Consider Before Investing in ETFs?

Here are some key factors that you need to consider before investing in ETFs:

1. The Expense to Income:

You ought to favor the ETF with a lower cost ratio when deciding between two ETFs that track the same benchmark, such as the Nifty 50. Generally speaking, it is desirable to have a smaller expense ratio.

2. Error in Tracking:

An ETF's returns may vary somewhat from the benchmark's returns. The fund management may retain some cash on hand to cover daily expenses, which is why it occurs. Tracking error is the distinction between the returns from an ETF and the benchmark returns. The ETF with a lower tracking error should be preferred when deciding between two ETFs that follow the same benchmark, such as the Nifty 50. According to the broad consensus, tracking errors should be as minimal as possible.

3. Securities Under Management (SUM):

A greater AUM ETF is the best option, in our opinion. The volatility of larger schemes may be lower. When selecting ETFs for investing, you should always place more significant weight on the expense ratio and tracking inaccuracy than AUM.

How Can Exchange-Traded Funds (ETFs) Help Investors?

When it comes to reducing the risk in your portfolio, ETFs may be a beneficial instrument. For instance, buying gold ETFs can help you diversify if your portfolio is excessively weighted toward stocks and debt. On the other hand, purchasing passive index ETFs that are safer, in contrast, is a quick and easy approach to increasing your exposure to stocks and decreasing your debt exposure.

How to Select ETFs?

Before making an ETF investment, four things need to be looked into. These are:

1. Type of ETFs:

The categories of ETFs include debt, gold, foreign exposure, and equities. It would help if you researched the industry you wish to invest in. Once you've chosen a category, search for its subcategories. For instance, if you invest in the equities ETF category, the equity subcategories would be based on capitalization, industries, etc.

2. The Volume of ETFs Trading:

Investors in ETFs have had liquidity problems in the past. But today, things have changed. Due to the increased popularity of ETFs and their high levels of liquidity, buying and selling ETF units has become simpler. 

A few ETFs do, however, have lower volumes of trading than others. Due to a lack of liquidity, selling your current units or purchasing new ones, such as ETFs, may be challenging. Therefore, always select an ETF with a healthy trading volume.

3. Spending Ratio:

The expenditure ratio may reduce your returns. It would help if you chose an ETF with a lower expense ratio than its competitors to earn greater returns.

4. Tracking Mistake:

ETFs are frequently developed to follow a particular index. They invest in index-related assets so that the returns "closely mirror" the indexes. The returns of the index and the ETF always differ from one another as a result. Make sure you pick an ETF with a slight tracking inaccuracy.

Are There Any Risks to Invest in?

It goes without saying that since this is a product with a market, there will always be a certain amount of danger. You must be completely aware of the following three risks associated with ETFs. 

First off, as this is a market product, it will fluctuate with the market just like any index, commodity, or stock would. The indicative NAV is where trading begins, but actual prices may vary depending on the state of the market and diverge from the value of the underlying asset.

Second, bid-ask spreads on ETFs may increase, increasing your risk, particularly in the case of ETFs that are not very liquid or that do not have sufficient market support. Last but not least, there is the tracking error risk, which poses the possibility that your ETF may not accurately represent the underlying index, which is what The initial goal of ETF is to achieve.

[ Related Article: Guide to Investing in Share Market ]

Can ETFs be Bought and Sold on the Stock Market?

That is what sets these ETFs apart from others. ETFs often trade and are listed on stock markets like any other stock. There are buyers and sellers, and the price is established by supply and demand and, naturally, by the underlying value of the questioned index or commodity.

Each ETF will be given a specific ISIN number, just like any stock, bond, or other asset held in Demat, and you can keep these ETFs in your Demat account in the same manner that you hold other shares and securities in your Demat account. ETFs don't require a unique layout. They are available for purchase and sale using your standard equities trading account. Just that straightforward, is it?

Final Thought

Make sure you know your investment options and develop a plan to meet your financial goals while considering your risk appetite and time horizon. Before purchasing an ETF, establish an investment plan and educate yourself on the intricacies of ETFs.
Being passively managed, they are designed to mimic the index's returns rather than beat them. Therefore, it's crucial to maintain reasonable expectations.

If you're a trader or investor who likes to stay on top of the market, you might also want to add ETFs to your portfolio for added stability. Before investing, consider your options carefully.

About Author

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Founder & Managing Director of Investor Diary

I, Vishnu Deekonda, am dedicated to providing the proper financial education to every individual interested in becoming financially independent through intelligent investments.

I have trained people to build financial independence and observed people had got many myths about investing for beginners. I want to prove to such individuals that these myths are the bottlenecks to a successful trading portfolio. I wanted to share the knowledge I have gained through a decade of experience with the people willing to build a healthy stock return with less or no risk.

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