Exchange traded funds pool the financial resources of several people and use it to purchase various tradable monetary assets such as shares, debt securities such as bonds and derivatives. Most ETFs are registered with the Securities and Exchange Board of India (SEBI). It is an appealing option for investors with limited expertise of the stock market.
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How do Exchange Traded Funds (ETFs) Work?
ETFs share characteristic features of both shares and mutual funds. They are generally traded in the stock market in the form of shares produced via creation blocks. ETF funds are listed on all major stock exchanges and can be bought and sold as per requirement during the equity trading time.
Changes in the share price of an ETF depend on the costs of the underlying assets present in the pool of resources. If the price of one or more asset rises, the share price of the ETF rises proportionately, and vice-versa.
The value of the dividend received by the share-holders of ETFs depends upon the performance and asset management of the concerned ETF company.
They can be actively or passively managed, as per company norms. Actively managed ETFs are operated by a portfolio manager, after carefully assessing the stock market conditions and undertaking a calculated risk by investing in the companies with high potential. Passively managed ETFs, on the other hand, follow the trends of specific market indices, only investing in those companies listed on the rising charts.
There are several advantages of investing in an ETF rather than opting for mutual funds or shares of a company.
Benefits over Investing in Companies: A Diversified Pool of Securities
Purchasing shares of a company keeps you limited to the performance of that company itself, subjecting you to a higher degree of risk. On the other hand, investing in exchange traded funds allow you to keep your finances spread over equities of different companies – diluting your risk significantly. Even if one asset underperforms in the pool of resources in an ETF, it can be compensated by the exceptional growth of other assets.
Benefits over Mutual Funds
- One of the significant benefits of investing in an ETF over mutual funds is the reduced expenses. There are various charges involved in mutual funds, such as entry and exit load, management fees, etc. This increases your total cost incurred, and thereby the total expense ratio of mutual funds.
As ETFs are traded like shares in the stock market, its expense ratio is considerably lower.
- The value of a mutual fund depends upon the performance of the NAV and can only be determined after the market closes for the day.
Any changes in the value of an ETF can be observed instantly and can be bought and sold throughout the business day.
Thus, we can conclude that ETFs have much higher liquidity than mutual funds. This enables you to have flexibility in your choices of investing, allowing you to shift to another security with ease in case a particular asset is not generating adequate profits.
- ETF funds are more tax-friendly than mutual funds. Even though both are subjected to capital gains tax and dividend taxes, the relative amount of fee charged on ETFs is much lower than the one levied on mutual funds.
- Investing in ETFs is generally less risky than mutual funds as they are passively managed. They only invest in the best-performing companies listed in a particular stock exchange, while mutual funds thoroughly asses all the businesses with a potential for growth. This subjects mutual funds to a greater risk as newly formed small scale companies have higher chances of incurring a loss.
Limitations of ETF
ETFs have certain shortcomings which you should be aware of before investing in an ETF trading company.
- Brokerage fees and Demat account
Since ETFs are traded like shares, there are several expenses which have to be incurred to purchase them. This is generally done by the fund managers, who charge a nominal commission fee for such transactions.
You can also opt to transact by yourself on the share market and not involve any fund managers in the process. A Demat account has to be opened in such a situation. Operating a Demat account requires basic knowledge of stock market transactions and its associated technique, which might be difficult for a novice.
- The volatility of the stock market
ETF companies listed on a stock exchange are subject to price fluctuations as per market trends. They are not stable like government bonds. Earning a profit or incurring a loss depends heavily on the stock market conditions.
Exchange traded funds have moderate diversity. As most ETFs are passively managed, they generally invest in best-performing companies listed on a particular stock exchange. ETF organisations often overlook small scale companies with huge potential.
Gold ETF vs Gold funds
Gold ETF refer to those mutual funds which invest primarily in physical gold assets. The asset base of the company comprises of 90-100% gold.
Gold funds, on the other hand, refer to mutual funds which invest in the shares of these ETFs. It is not tangible and represents a financial asset purchased by you. A benefit of investing in a gold-based mutual fund is that it does not require a Demat account for transactions.
The most common types of ETF funds( India) are:
- Equity ETF – These represent companies investing in shares and other forms of equity of various organisations.
- Gold ETF – This is a commodity exchange-traded fund primarily involving physical gold assets. Purchasing shares of this company allows you to become the owner of gold on paper, without the burden of asset protection.
- Debt ETF – Enterprises trading in fixed return securities such as debentures and government bonds are often called Debt ETFs.
- Currency ETF – Currency ETF funds mainly profit due to the fluctuation of the exchange rates. They purchase the currency of different countries based on calculated predictions about the future performance of that currency. Currency ETFs follow not only the stock exchange trends but also the political and economic scenario of the respective countries.