Getting started with ETF : Key types and investment strategies
ETFs have become a popular investing instrument applicable in the financial market. It offers investors a convenient means to diversify their portfolios and build wealth. With this instrument, they can gain broad market exposure while lowering their risks. Knowing about ETFs can help investors harness the power of various assets and meet their financial objectives.
The growing popularity of ETFs is due to their unique features and benefits. In fiscal year 2024, the National Stock Exchange (NSE) of India saw the trading volume of ETFs surpass INR 1.19 trillion. It underlines an upward trend in trading volume since the fiscal year 2017.
This article offers insights into ETFs, including ETF meaning, definition, benefits, investment strategies, and more.
What Is ETF: Understanding ETF Meaning, Definition, and Basics
An Exchange-Traded fund (ETF), is an investment fund that is listed and traded on exchanges.
It means an individual can buy or sell this investment fund on a stock exchange like a stock. Such a fund generally tracks a specific index and attempts to replicate its return.
By investing in ETFs, investors can gain exposure to a wide range of assets, such as equities, bonds, commodities, etc. This offers them the opportunity to diversify their portfolio. The best part is that they can do so with relative cost efficiency and limit their risks.
In short, ETFs combine the diversification power of mutual funds with the trading flexibility of stocks. Due to their hybrid nature, they enjoy enhanced liquidity.
ETFs were first launched in 1993. Since then, this asset class has continued to evolve in scope and size. In 2003, there were just 276 ETFs worldwide. By 2023, this number reached 10,319, signifying the exponential growth and increasing popularity of this asset class.
Who Creates an ETF and How?
ETFs are created by large institutional investors, known as authorized participants (APs). The process of creating ETFs involves APs and ETF issuers.
To create ETF shares, an AP provides the issuer with a basket of securities and/or cash, called a creation basket. In exchange, the AP receives a fixed amount of ETF shares from the issuer, known as a creation unit.
The AP may decide to keep these shares or sell them on the secondary market. To sell the shares on the secondary market, they are first listed on the stock exchange. Once listed, they become available to retail investors for buying and selling.
How Do ETFs Work?
ETFs follow a simple working principle. In an ETF, the fund provider holds the underlying assets and is designed to track performance. The fund provider sells the ETF shares to investors. It’s important to note that ETF investors own a part of the fund; they don’t own the ETF’s underlying assets.
ETFs are traded on the stock market, so their prices are determined by supply and demand. This means that, at any given moment, the price of an ETF might be slightly different from the combined value of its underlying assets. However, this difference is typically short-lived.
Market mechanisms, like arbitrage, help keep ETF prices in line with the value of their assets. So, while an ETF’s price may briefly stray from the actual value of its holdings, it generally returns to match the underlying asset value closely over time. The changes in the valuation of the ETF units depend upon the changes in the investment portfolio.
Investors can purchase and sell ETFs during the exchange’s trading hours. Since an ETF’s traded price changes during the day, investors can profit from intra-day price movements.
ETFs are managed either actively or passively. An actively managed ETF has a portfolio manager who analyses the stock market and invests in high-potential firms. In the case of a passively managed ETF, the fund capital is invested in firms that are rising in certain market indexes.
ETFs vs. Mutual Funds
ETFs and mutual funds are two prominent investment instruments that offer exposure to multiple asset classes and niche markets. They provide opportunities for low-cost portfolio diversification.
While ETFs and mutual funds have similarities, they differ in several ways. Here are the key differences between ETFs and mutual funds.
| ETF | Mutual Fund | |
| Investment Approach | Passively managed investments that track an underlying asset class or index. | Actively managed investments in which fund managers seek to outperform the market through strategic buying and selling. |
| Trading Flexibility and Liquidity | Investors can buy and sell ETFs on the stock exchange throughout the trading hours, which enhances their liquidity. | Investors can buy or sell mutual funds only at the end of the trading day, at the net asset value (NAV) price. |
| Cost Efficiency | Lower expense ratios as they are passively managed. | Attract higher fees as they are actively managed by fund managers and require ongoing market analysis. |
| Taxation | More tax-efficient due to lower capital gains. | Less tax efficient due to higher capital gains. |
Knowing about these differences can help investors make informed decisions and shape their portfolios.
Types of ETFs
ETFs can be categorised into various types based on their investment focus. Understanding the different types of ETFs will help investors to make informed decisions. Here are some of the common types of ETFs:
1. Index ETF
An index ETF tracks particular market indexes, such as the Sensex and Nifty 50. Investors don’t need to select individual stocks, and investing in an index ETF offers broad diversification.
2. Equity ETF
Equity ETFs allow an individual to invest in a basket of equities or company shares. The shares can be categorised in different ways, such as those from large companies, small businesses, upcoming companies, etc. This provides a wide choice of equity ETFs.
3. Bond ETF
Bond ETFs provide exposure to different fixed-income tools, such as debentures, Government bonds, corporate bonds, etc. Bond ETFs do not come with a maturity date.
4. Sector ETF
Sector ETFs enable investors to invest in a specific sector, such as banking, technology, oil, real estate, etc. In other words, these ETFs provide exposure to companies that operate within particular sectors.
5. Commodity ETF
Commodity ETFs track the price of commodities or raw materials, such as metals, natural resources, agricultural goods, etc. In India, silver and gold ETFs are the only commodity ETFs available currently.
6. Foreign Market ETF
Foreign market ETFs are designed to offer exposure to international markets, such as the Hang Seng Index in Hong Kong or the Nikkei Index in Japan. They provide an easy way to take part in the growth of global markets by tracking their indices.
7. Inverse ETF
An inverse ETF monitors the decline in an underlying market or ETF and enables investors to make a profit out of it. Such an ETF moves in the opposite direction of the underlying asset. Investors can use these ETFs as hedging tools.
Benefits of Investing in ETFs
ETFs offer multiple benefits for investors. Some of the major benefits are as follows:
1. Diversification
ETFs offer investing scope in a basket of assets, such as equities, commodities, specific sectors, etc. This empowers investors to diversify their portfolios.
2. Tax-Efficient Returns
ETFs usually generate fewer capital gain distributions. Such returns result in lower taxes for investors. This makes passively managed ETFs more tax-friendly compared to actively managed mutual funds.
3. Lower Costs
Investing in ETFs attracts lower costs than investing in mutual funds. Such costs include operating expenses, trading expenses, management fees, etc.
ETF Investment Strategies
When investing in ETFs, investors can follow different strategies based on their financial goals and risk tolerance. Here are some strategies for investing in ETFs:
1. Long-Term Strategy
In this strategy, an investor purchases and holds ETFs with low expense ratios for a long period, usually 10 years or more. They use ETFs as core building blocks of their portfolio and ensure diversification.
2. Short-Term Strategy
This strategy involves investing in ETFs for a short time, which can extend from a few days to a couple of weeks. It helps investors take advantage of specific market trends and can also be used for tactical asset allocation.
3. Cost-Averaging Strategy
This strategy requires an investor to buy a fixed number of ETFs at regular intervals. By opting to invest at regular intervals, an investor can average the cost of the ETFs. The period of investment may extend from a few months to several years.
Risks Involved in ETF Investments
While ETFs limit the risks involved in stock market investments, they are not completely risk-free. Some potential risks associated with ETFs are as follows:
1. Market Risk
All investments in the stock market are subject to volatility and market fluctuations. This holds for ETFs as well. The risk is comparatively lower when an ETF tracks a large index. However, it is not totally eliminated.
2. Liquidity Risk
Every ETF may not experience high liquidity. Some may have low liquidity due to several reasons, such as the low trading volume of their underlying assets. This may create challenges in buying or selling the ETFs at favourable rates.
3. Portfolio Risk
ETFs can be of various types, and choosing the right ones is essential for meeting financial goals. If an individual fails to make the right selection, it can result in portfolio risk.
Monitoring ETF Investments
Analyzing and monitoring your ETF performance is a continuous process. It helps to make informed investment-elated decisions. Here are a few tips for tracking ETF performance and making adjustments:
- Use online analytical tools to track ETF performances and gain valuable insights about the risk metrics.
- Review the performance of ETFs regularly. It will help to identify any potential issues and make necessary adjustments.
- Compare the performance of the ETFs against their benchmark indices. This will enable you to evaluate whether the ETFs are underperforming or outperforming their benchmarks.
Conclusion
ETFs are a useful and convenient instrument for investing in the financial market. Whether you want to diversify your portfolio with targeted or broad exposures, ETFs are well-suited for both. Thanks to their low costs and trading flexibility, you can consider them for short-term and long-term investments.
The best part is that once you know about the ETF meaning, definition, and basic concept, you can start using this investment tool to meet your investing goals. Just make sure to choose the right ETFs to maximize your return potential.
FAQs on ETF
1. What Is the Settlement Time for ETFs?
The settlement time for ETFs is one business day after the trade execution date. It is called the T+1 settlement cycle, where T refers to the trade date.
2. Who Should Invest in ETFs in 2024?
ETFs are a suitable investment option in 2024 for both new and experienced traders. Anyone who wants to expand their exposure to different asset classes can consider these funds.
3. Can investors short-sell ETFs and buy on margin?
Since ETFs trade on exchanges like stocks, they conform to the same trading strategies. Investors can buy these funds on margin and short-sell them during day trading.
4. Do Investors Need a Minimum Investment Amount for ETFs?
ETFs in India do not require a minimum amount to invest in. However, investors must purchase the ETFs as whole shares, just like stocks.
