To say exchange-traded funds (ETF’s) are enjoying a high right now is an understatement, ETFs have become the darlings of the investing world.
In the first two months of 2018, new funds launched at a pace faster than one per day. And a recent survey conducted by BlackRock found that 62% of investors planned to buy an ETF in the next 12 months.
Despite their popularity or perhaps because of it, ETFs have attracted detractors.
But there’s still skepticism about how safe they are, especially when the Indian market crashes.
Let’s look at ETF in more detail.
Exchange-traded fund(ETF) is kind of an index fund that invests in an index, a commodity, currencies, bonds etc. ETF is an excellent investment instrument for achieving investor’s goals, provided used wisely.
When you invest in ETFs, your money is invested in a bunch of market securities which are part of a pre-determined index. The investment is made in the same proportion as the index.
However, unlike index funds or other mutual funds, ETFs are traded on the stock exchange, and they experience price changes throughout the day whereas mutual funds are valued once in a day.
These changes in the price are dependent on the demand and supply of the ETFs. The country’s first ETF, Nifty BEES tracks the S&P CNX Nifty Index while ICICI Prudential’s SPiCE tracks the BSE Sensex.
While the index funds and ETFs have started attracting a big chunk of the investors’ money in the developed markets, these passively managed funds are yet to pick up in India. This is because the actively managed funds continue to outperform their benchmarks till the Indian stock market starts crashing big time.
Pros and Cons of ETF
Let’s go through both, the pros and cons of investing in ETF and after that, you will be able to make a better investment decision.
Source: Live Mint
1.They are listed and traded on a stock exchange like common stocks. So, they can be bought and sold at any time of the day.
2.ETF includes almost every investing asset class including commodities or currencies. It gives you exposure of any market, any sector in the world.
3. Investors can place different types of order for buying ETFs like stop-loss order, buy on margin etc, as they are traded like stocks in the market.
4. ETFs are known to be very cost effective when compared to other funds.
This is because there isn’t a lot of management cost involved in the transactions. They are economical for a small investor and they are known to turn oucheaper overer a long period of time.
5.ETFs aim at simplicity. They are very transparent in nature and they have a very simple structure.
Unlike other mutual funds which are managed actively by a fund manager who decides where the funds are allocated, ETFs are meant to emulate a particular index, commodity or currency which makes it easier for the investor to understand how his funds are being allocated.
6. By mimicking an index, ETFs provide diversification in the investment.
Just one trade will help you gain a basket of securities or assets. There is no better way to reduce risk than to diversify your funds.
With ETFs, your job is made easier since it automatically diversifies the funds.
7. While ETFs need to be managed just like any other fund, they do not require active management by a fund manager. They aim at tracking the index without trying to outperform it.
1.As ETF includes a wide range of investment options, deciding on a particular instrument can sometimes get difficult for an investor.
2.Proper knowledge of ETF is needed to invest.
3.A primary risk with ETF is that of liquidity. The buying and selling price of this financial instrument can differ greatly.
4.Another problem is that the Indian investment market is yet to explore the complete potential of ETFs.
The market is not very mature for ETF investments of various kinds. With limited options, ETFs are often not considered to be the choice of investment for many investors.
5. For investing in global ETFs, the following fundamentals and credit worthiness of currency in that country is very essential.
Along with this, economic, social and political instability can also hurt your investment.
6.Tracking error which appears in funds that track an index can also become a risk for an ETF.
If you find that the tracking error is very high, then these funds will carry a higher risk. This is because some fund managers buy only a few stocks and bonds in an index which may cause the ETF to over-perform or under-perform.
Can an investor consider switching to ETF?
Source: Bodhik Blog
It may be the right time to switch to ETFs if mutual funds are no longer meeting your needs. For some, switching to ETFs makes sense because the expenses associated with mutual funds can eat up a substantial portion of profits.
If you’re paying fees for a fund with a high expense ratio or finding yourself paying too much in taxes each year because of undesired capital gains distributions, switching to ETFs is likely the right choice for you.
But remember, like any investment, ETFs aren’t risk-free.
When considering ETFs, it’s important to understand what you own and why. While the number of ETFs available for investment continues to expand, simple portfolios consisting of a handful of funds can help you achieve your retirement goals.
Also, just because you can trade an ETF regularly doesn’t mean you should. These investments can, and should, be a part of a long-term investment strategy.
ETFs might be a good start for risk-averse investors, for those who have just started investing or for those who just want to passively earn returns by tracking the indices.
However in India, on an average, actively managed funds tend to outperform than the benchmark index which is why the ETF strategy does not work as well as active funds here.
ETFs are a volatile investing instrument, as you would expect, because they invest in market securities, but they are not the source of the volatility.
Finally, market stress is also reflected in ETF prices just as it reflects in its underlying securities. So consider the various parameters before investing in ETFs. Make sure that the investment instrument is suitable for your risk appetite and alsways have a duration of investment in mind.
Disclaimer: The views expressed in this post are that of the author and not those of Groww