WTF Is An ETF? Enhance Your Portfolio With Exchange-Traded Funds

WTF Is An ETF? Enhance Your Portfolio With Exchange-Traded Funds

Binged episodes after episodes of a gripping series on OTT?

Guilty as charged!

These platforms club multiple genres together to become a holistic entertainment package. That’s precisely how ETFs (Exchange-Traded Funds) work in the world of investing!

The investment landscape in India has witnessed a significant shift recently, with passive investing gaining traction among new investors and financial experts. Sensex and Nifty are India’s two most widely traded benchmarks, and the latter represents the country’s 50 largest companies by market capitalization. Investors seeking exposure to the market often wonder: What’s the most structured and efficient way to invest?

Exchange-traded funds are the answer!

What started in Canada in 1990 cascaded into India in 2002 with the launch of NiftyBeES. It was the first ETF tracking the Nifty 50 index, which is now under the purview of the Nippon India Mutual Fund. 

An ETF is an investment fund that holds multiple underlying securities, such as equities or bonds. These assets can be bought and sold in exchange, much like any other individual stock. This investment vehicle enables investors to gain exposure to a broad range of assets without having to buy multiple individual assets.

Combining the flexibility of stocks and the portfolio-diversifying strengths of mutual funds, ETFs enhance liquidity compared to traditional funds with relative cost efficiency. 

Just like stocks, you can trade ETFs on stock exchange platforms (National Stock Exchange and Bombay Stock Exchange) during market hours. A fund provider owns the underlying assets, forms a fund to track their performance, and offers shares in that fund to investors. Shareholders own a part of an ETF but not the fund’s assets. 

In short:

  • An ETF provider analyzes and creates a basket of securities, including stocks, bonds, commodities, and currencies.
  • Investors can buy a share of that basket using their brokerage account or through Stack’D.
  • Buyers and sellers trade the ETF throughout the day, much like stocks.

Now that you know what ETFs are, here’s why you should invest in them:

  • Diversification: Exchange-traded funds enable instant diversification across a mix of asset classes, reduce risks, and maximize returns.
  • Transparency: Most ETFs are required to disclose their daily holdings, providing investors with clear visibility into the various underlying assets.
  • Accessibility: Foreign market ETFs, Commodity ETFs or Fixed Income exchange-traded funds allow investors to invest in emerging markets.
  • Matches index performance: ETFs track indexes and match the performance of underlying assets, thereby eliminating the guesswork in investing.
  • Trading Flexibility: Swiftly move across asset classes and simply buy and sell an ETF anytime during market hours through your broker at the market price with no minimum purchase requirement.
  • Cost-efficiency: Operating expense ratios for ETFs tend to be lower than actively managed mutual funds.
  • Tax efficiency: ETFs have lower turnover rates than actively managed funds. Therefore, they result in fewer capital gains and lower tax implications for investors.
  • Stability: You know exactly what index returns to expect. So, your portfolio is stable, especially during volatile market periods when active funds may suffer a heavier blow.

However, ETFs, like any other financial product, are not a one-size-fits-all solution. They also contain risks.

  • Lower liquidity: Some unpopular ETFs have wider bid-ask spreads, which indicates you buy at a higher price and sell at a lower price.
  • Settlement dates: ETF sales are not settled for two days after the transaction. This implies that, as the seller, your money from the ETF sale will be unavailable for reinvestment for two days.

Exchange-traded funds have captured significant global market interest. According to the J.P. Morgan Equity Derivatives Strategy report, as of the end of May 2024, there were around 12,000 ETFs listed globally. The report also stated that total assets under management (AUM) were around $13 trillion, up from $10.1 trillion the previous year. 

Whether you are a beginner looking to invest or a seasoned financial professional, ETFs are a powerful investment option to help you meet your goals.

1. Do ETFs pay dividends?

Dividends are a portion of money allocated to investors. ETF shareholders are entitled to a share of earned interests as long as the underlying stock held within the ETF pays dividends. These dividends are distributed to investors quarterly, based on the number of shares one owns in the ETF.

2. How do ETFs differ from mutual funds?

While both ETFs and mutual funds provide diversification and exposure at low costs, they differ in other respects:

  • ETFs are passive investments, whereas mutual funds are often actively managed.
  • Some brokers charge commissions while buying or selling mutual funds; ETFs typically have no commission.
  • Mutual funds are priced at the fund’s net asset value (NAV), calculated at the end of each day. However, exchange-traded funds are traded during market hours.
  • Mutual funds are forced to distribute capital gains, which can increase your tax bill, whereas ETFs offer better tax efficiency.

How do ETFs differ from stocks?

While ETFs are traded like individual stocks, there’s a fine line of difference between the two:

  • An ETF is composed of a mixed bag of stocks and bonds. Individual stocks are more volatile than a collection of stocks.
  • Since ETFs include multiple assets, they provide better diversification than a single stock, further reducing your portfolio’s exposure to risk.
  • Individual stocks don’t charge an expense ratio. In contrast, exchange-traded funds charge an ongoing expense ratio.
  • An individual stock requires more analysis before trading. It is also riskier as its value is directly proportional to the company.

Disclaimer: Mutual Funds investments are subject to market risk. Please read all the scheme-related documents carefully.