ETF (Exchange Traded Funds) Meaning, Types & Benefits | ICICI Bank

ETF means an Exchange Traded Fund. It can be defined as a type of investment fund that is traded on stock exchanges, much like individual stocks. It holds a collection of assets like stocks, bonds, or commodities, and its value changes throughout the day based on market fluctuations. ETFs are reputed for offering low-cost diversification and high liquidity, making them ideal for both beginners and seasoned investors.

This comprehensive guide explores what ETFs are, how they work, their advantages and disadvantages and how to invest in them.

What is an Exchange Traded Funds (ETF)?

An Exchange Traded Fund (ETF) is a fund that tracks an index, sector, commodity, or asset and can be bought and sold on stock exchanges just like regular shares. ETFs aim to mirror the performance of a particular index, like the Nifty 50 or Sensex, by holding the same securities in similar proportions. Investors can trade ETFs during market hours, and they typically have lower expense ratios compared to mutual funds.

ETFs are passive investments, meaning they don’t require active management. They simply follow the index or basket of assets they are designed to replicate. This makes them cost-effective and transparent for investors. With an ETF, you gain exposure to a wide range of stocks or bonds without having to buy each one individually.

How do ETFs Work?

ETFs work by tracking the performance of a specific index or sector. Fund managers create ETFs by assembling a basket of securities that mirrors the index they are designed to follow. These units are then listed on stock exchanges for public trading.

Here’s how the process works:

1. The ETF provider selects a set of underlying assets like Nifty 50 stocks, gold, or government bonds, and forms a fund based on those assets. This basket of securities is designed to mirror the performance of a market index or a specific sector.

2. Once the fund is formed, the provider lists it on a stock exchange. Investors can then buy shares of the ETF through the exchange, just like buying stocks. These shares represent a portion of the entire ETF portfolio but do not give direct ownership of the underlying assets.

3. The ETF’s price fluctuates throughout the trading day based on supply and demand, just like a stock. Investors can trade ETFs at any time during market hours, offering more flexibility than traditional mutual funds, which are only priced once a day.

Types of Exchange-Traded Funds

ETFs can be categorised based on where they invest, providing investors with diverse options to suit their investment goals. Here are some popular types of ETFs:

Equity or Market Exchange Traded Funds (ETF)

These ETFs aim to track a particular equity index, such as the NIFTY 50 or SENSEX. These ETFs expose investors to a broader market or a specific segment.

Thematic or Sector Exchange Traded Funds (ETF)

Thematic or sector-specific ETFs focus on specific industries or themes, such as pharmaceuticals, technology or oil. Rather than mirroring the overall market, they invest in a basket of stocks related to a specific sector or theme.

Commodity Exchange Traded Funds (ETF)

Commodity ETFs track the price movements of commodities like gold, silver or oil. Investing in these ETFs allows you to participate in the commodity markets without physically owning the commodities.

International Exchange Traded Funds (ETF)

International ETFs provide exposure to foreign markets such as the NASDAQ 100 or Hong Kong's Hang Seng Index. They offer a convenient way to diversify a portfolio with international assets.

Inverse Exchange Traded Funds (ETF)

Inverse ETFs, also known as Bear ETFs or Short ETFs, aim to deliver the opposite performance of a specific index. Investors profit when the index declines and incur losses when it rises.

Leveraged Exchange Traded Funds (ETF)

These ETFs use leverage and derivative instruments like futures, options and swaps to amplify returns. They allow investors to take larger positions with relatively less capital.

Bond Exchange Traded Funds (ETF)

Bond ETFs, also known as Debt ETFs, add a debt component to portfolios. They invest in fixed-income securities and generate income from interest payments.

Advantages and Disadvantages of ETF

Benefits of Investing in ETFs

Investing in ETFs comes with several important advantages that make them a popular choice for a wide range of investors:

1. Diversification

ETFs offer broad market exposure as they often include dozens or even hundreds of securities. This helps reduce risk since your money is not tied to the performance of a single stock or bond.

2. Low Costs

ETFs have lower expense ratios compared to mutual funds. Since most ETFs are passively managed, fund management costs are minimal. This helps investors retain more of their earnings.

3. Liquidity

You can buy or sell ETFs on the stock exchange at any time during market hours. This real-time trading offers flexibility and allows investors to react quickly to market conditions.

4. Transparency

ETF holdings are disclosed daily, unlike mutual funds that disclose them monthly or quarterly. This helps you track exactly where your money is going.

5. Tax Efficiency

ETFs are more tax-efficient than mutual funds because of their unique “in-kind” creation and redemption process, which reduces capital gains distributions of their unique creation and redemption process, which helps minimise capital gains distributions.

Risks of ETFs

ETFs are often known as low-cost investments, but there are certain risks to know about:

• The first crucial thing to know is that if you invest small amounts regularly, buying directly from a fund company may sometimes be cheaper than through an ETF.

• It is also important to know that the lightly traded ETFs may have large bid-ask spreads. It means you may end up buying at a higher price and selling at a lower price, which increases trading costs and impacts returns.

• There may also be a risk of slight differences in performance between the ETF and its underlying index due to technical issues.

Things to Consider While Investing in Exchange Traded Funds (ETF)

Before investing in ETF Mutual Funds, consider the following factors:

Past Performance:

While past performance doesn't guarantee future returns, it is essential to assess and compare a fund's historical performance with similar funds.

Trading Volume:

Higher trading volume indicates better liquidity and narrower bid-ask spreads. Look for ETFs with sufficient trading volume to ensure easy buying and selling.

Expense Ratio:

ETFs typically have lower expense ratios than actively managed funds. Choose ETFs with lower expense ratios to maximise your returns.

Tracking Error:

Tracking error, measures how closely an ETF replicates its underlying index's performance. Lower tracking error indicates better tracking of the index.

How to Invest in an ETF?

Follow this quick guide to start investing in ETFs:

1. First, there is a need to open a brokerage account from a reliable platform and then complete the registration process.

2. Carefully research and then choose an ETF that matches your investment goals.

3. Lastly, you need to fund your account and place an order to buy the chosen ETF.

Who Should Invest in ETFs?

ETFs are a great fit for a variety of investors depending on their goals, risk tolerance, and market knowledge.

1. Beginners

ETFs provide easy access to a diversified portfolio with minimal costs. New investors looking for passive exposure to the stock market can start with ETFs.

2. Busy Professionals

If you don’t have the time to actively manage your investments, ETFs offer a “set-and-forget” approach. They automatically track the index or sector, saving you effort.

3. Cost-Conscious Investors

With low expense ratios and no fund management fees, ETFs are suitable for investors who want to keep costs under control.

4. Long-Term Investors

ETFs can form the core of a long-term investment strategy. Investing consistently in ETFs helps build wealth over time with less volatility compared to individual stocks.

5. Experienced Traders

Traders can use ETFs for tactical asset allocation, sector rotation, or even hedging because they allow intraday trading.

How Are ETFs Different From Index Funds?

While ETFs and index funds share similarities, they differ in several ways:

Management Style:

Index funds are usually passively managed, while ETFs can be either passively or actively managed.

Liquidity:

ETFs are traded on stock exchanges, allowing intraday trading and potentially higher liquidity. Index funds are priced at the end of the trading day.

Need for Demat Account:

Investing in ETFs requires a Demat Account, while index funds can be purchased without one.

FAQs

What is an ETF Fund?

An ETF fund is a type of mutual fund that’s traded on stock exchanges. It holds a basket of assets and aims to track a specific index, sector, or commodity.

Are ETFs safe to invest in?

Yes, ETFs are safe if you understand the market risks. They offer diversification, which helps reduce risk, but the value of ETFs can fluctuate based on market performance.

Can I invest in ETFs with a small amount?

Yes, you can start with just the cost of one unit of the ETF. There is no fixed minimum like mutual funds, making them accessible to small investors too.

Do ETFs pay dividends?

Yes, many ETFs pay dividends if the underlying stocks in the fund issue them. These dividends are either paid out or reinvested, depending on the ETF structure.

How can I buy or sell an ETF?

You can buy or sell ETFs through your demat and trading account, just like stocks. Place orders during market hours using your broker’s online platform.

Are ETFs better than mutual funds for beginners?

ETFs are great for beginners seeking low-cost, diversified, and passive investment options. However, mutual funds may offer more flexibility for those preferring SIPs and professional fund management.

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