Exchange-Traded Fund (ETF): What is an ETF and Its Various Features

If you want to invest in equity but lack the knowledge and expertise, ETF can be an excellent option for you. Please read this post to know what they are and understand some of their top features.

Equity markets have proven their worth over the years. They have the highest returns potential and are an excellent option for anyone aiming for long-term wealth creation. But they do have the highest level of risk too.

It takes a lot of knowledge and experience in selecting stocks that could turn into multi-baggers and deliver exceptional returns to the investor. But what about an investor who wants to invest in equity but lacks the knowledge? ETFs can be the way to go.

Let us have a look at what these funds are and understand their various benefits:

Exchange-Traded Funds or ETFs are index funds that are listed on stock exchanges. Just like you buy/sell stocks of various companies on stock exchanges, you get the same option with ETFs. Just like index mutual funds, ETFs mimic an underlying index, such as Nifty NSE, BSE Sensex, etc.

An ETF might also create its custom index. So, an ETF that tracks Nifty NSE will have the same 50 stocks that make Nifty NSE and in the same proportion. But unlike index funds where you are required to redeem the fund units at the current NAV through your fund house, you can buy/sell shares of ETFs from stock exchanges. Just like stocks, their prices fluctuate throughout the trading session.

Moreover, apart from equity, ETFs can also have bonds, commodities, or a mixture of different securities.

Now that you have understood what is an ETF, check out some of its top features-

• Passive Style of Investment

  Most types of equity and debt funds have an active style of investment. The fund manager continuously adjusts the portfolio and buys/sells securities to generate higher returns. But ETFs have a passive method of investment. The only thing that the fund manager focuses is to match the composition of the underlying benchmark as accurately as possible.

• Lower Expense Ratio

  Due to their passive style of management, ETFs also have a lower expense ratio. This is because the regular buying and selling that takes place in other types of funds is not required in ETFs.

  Once the portfolio is built as per the underlying benchmark, adjustments would only be needed if there are any changes made to the underlying benchmark.

• Less Risky Than Direct Equity Investment

  As ETFs consist of various securities, the risk is significantly lower than when you invest your money in a single stock or a few different stocks. Also, indices like Nifty and Sensex are only made up of quality stocks.

  So, by investing in an ETF mutual fund that tracks these indices, you indirectly get to invest in quality stocks only, which again minimises the risk.

• Ideal for New Investors

  New investors planning to invest in the equity market often struggle with stock selection. With ETFs, they can invest in equity even if they do not have the required stock selection skills.As investment is always in line with the underlying benchmark, neither the investor nor the fund manager is required to regular search for profit-making opportunities.

• Easy Diversification

  A stock index like Nifty consists of stocks from different industrial sectors such as Banking/Finance, Technology, Pharmaceuticals, Automotive, Oil & Gas, and more. So, by investing in an ETF that tracks Nifty, an investor automatically gets to diversify his/her investment.

  Selecting quality stocks from various sectors requires not only a lot of knowledge but also a considerable investment amount. ETFs make diversification easier to achieve in a cost-efficient manner.

If ETFs suit your investment goals, here are a few tips to help you pick the best fund:

• Underlying Benchmark:

  As mentioned above, ETFs can be made up of stock indices, commodities, bonds, or a mixture of different securities. To narrow down your research, select the type of market that you’d like to invest. You can then browse through ETFs that invest in your preferred market/instrument.

• Trading Volume:

  It is better to select ETFs that have high trading volumes on exchanges. This helps in keeping the bid/ask spread and investment cost low. It is easier to buy/sell shares of ETFs with higher trading volume. So, once you have narrowed down to a particular index/instrument, the trading volume of the available ETFs will help make the selection easier.

• Minimum Tracking Error:

  While the fund managers try to mimic the underlying benchmark as accurately as possible, there is some amount of error. This is known as the ‘tracking error’. Prefer funds that have minimum tracking error as this will ensure that the returns generated by the fund and by the underlying benchmark are similar.

• Expense Ratio:

  The expense ratio is a type of expense for mutual fund investors. While open-ended funds have a higher expense ratio as compared to close-ended schemes like ETFs, there can still be significant differences between the expense ratio of two ETFs. It can range from 0.50% to 0.75%. Prefer an ETF with a lower expense ratio.