Exchange Traded Funds (ETFs) are a type of investment fund that tracks an index, such as the S&P 500. ETFs are traded on stock exchanges like stocks and can be bought and sold throughout the day. This makes them more flexible than mutual funds, which can only be bought and sold at the end of each trading day. Read on to learn more about them.
Understanding Exchange Traded Funds (ETFs)
ETFs are open-ended
Exchange Traded Funds (ETFs) are open-ended index mutual fund schemes that are listed and traded on stock exchanges. ETFs invest in a basket of securities that mirror a specific market index. In India, ETFs track benchmarks like Nifty 50, Sensex, gold prices, and government securities. Unlike regular mutual funds, ETF units can be easily bought and sold in real-time on exchanges just like stocks. ETFs combine the diversification and low costs of index funds with the flexibility of intraday trading like equities.
ETFs offer diversification
Since ETFs replicate popular indices, they provide instant diversification at low costs. Expenses are minimized as no active fund management is required unlike actively managed schemes. ETFs have expense ratios under 1% whereas regular mutual funds average 1.5-2.5%. As ETFs mostly follow passive indexing strategies, their operating costs are significantly lower. Lower costs enhance returns over long-term investing horizons.
ETF NAV aligns with the underlying index
ETFs maintain close correlation with underlying index through the arbitrage mechanism. When ETF price deviates from Net Asset Value (NAV), authorized participants step in to profit from the price difference. If units trade above NAV, they sell ETFs and redeem basket of securities from the fund house to pocket the premium. If units trade below NAV, they buy ETFs from the market and exchange them with the fund house for underlying securities. This arbitrage window ensures efficient price discovery and alignment of ETF valuation with the index.
Evaluate ETFs on tracking error, liquidity and assets under management
When evaluating ETFs tracking the same index, consider key metrics like tracking error, liquidity and assets under management (AUM). Tracking error measures deviations in ETF returns from the index due to fees and expenses. Prefer ETFs with lower tracking error. Check liquidity by comparing average trading volumes and impact cost – a measure of trading expense from bid-ask spread and depth. Finally, choose ETFs with higher AUM for tighter spreads and trading close to NAV.
Explore ETFs across asset classes like equities, bonds, gold and global indices
ETF options exist across asset classes beyond equity indices like Nifty and Sensex. Debt ETFs track government bond indices and offer stable income. Gold ETFs mirror domestic gold prices and add diversification benefits. ETFs are also available on global benchmarks like Nasdaq 100 and S&P 500 for international diversification. Explore suitable ETFs tracking desired markets and assets based on your overall asset allocation needs and risk profile.
Take a holistic view and monitor overall portfolio in terms of targeted asset allocation and performance versus financial goals. Rebalance across ETFs periodically to restore intended allocations. Employ a buy and hold approach for long term strategic ETF investments and use SIPs to accumulate units. Limit trading to tactical asset allocation only where necessary based on market outlook.