What is Exchange Traded Fund? Experts decode meaning, advantages and disadvantages of ETF

Exchange traded funds or ETF: Diversifying one's portfolio beyond stocks is essential in the present market. Experts have repeatedly stressed on the mantra of diversification. Added to the list is one more investment option, Exchange traded funds or ETFs which not only helps in diversifying the portfolio but is easy to invest in too. 

What is Exchange traded funds or ETFs? 

Exchange traded funds or ETFs provide a combination of the flexibility of stocks and the portfolio-diversifying strengths of mutual funds. ETFs give investors an affordable way to access a wide variety of asset classes.

An ETF is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. 

Also read: Layoffs in 2023: How to manage your finances amid job cuts 

According to Utkarsh Sinha, Managing director Bexley Advisors, ETFs are simply open-ended funds that consist of units which can be freely traded on an exchange.

History of ETF

According to Amar Ranu, Head - investment products & Advisory, Anand Rathi Shares & Stock Brokers, India's first ETF — the Nifty Benchmark Exchange-Traded Scheme (Nifty BeES) — was launched in the year 2002 by Nippon Asset Management Company. It tracks the top 20 companies of the Nifty 50 index. Later on, in the year 2007, first commodity based ETF was launched by the same AMC called the Gold BeEs ETF.

How do Exchange Traded Funds work? 

When an investor buys an ETF, they buy a bundle of assets that can be bought and sold in the regular stock market hours. 

Who can invest in ETFs? 

According to Pritam Deuskar, Founder of Wealthyvia, exchange-traded funds can be traded by anyone with a brokerage account, including individual investors, financial advisors, and institutional investors. 

How to trade in ETFs? 

Nidhi Manchanda, Certified Financial Planner, Head of Training, Research & Development at Fintoo, says one can invest in ETFs by following four simple steps:

Step 1: Open a Demat and Trading account with a stock broker.

Step 2: Have sufficient funds in brokerage account to place orders to buy the ETFs

Step 3: Investors while placing the buy and sell order will incur charges such as brokerage fees, transactions cost and taxes.

Step 4: Investors after buying the units of ETFs from the stock exchange can track the performance of the ETFs on a real time basis from their Demat account as ETFs are electronically stored in the Demat account of the investors.

Note: The transaction and settlement cycle for ETFs are similar to that of individual stocks, i.e T+2.

Also read: Layoffs in 2023: How to manage your finances amid job cuts 

Benefits of Exchange Traded Funds or ETFs

According to experts following are the advantages of ETFs — 

Low Costs: ETFs often have lower expense ratios compared to actively managed mutual funds, making them an attractive option for cost-conscious investors.

Liquidity: ETFs are traded on stock exchanges and can be bought or sold throughout the trading day, providing increased flexibility and ease of trading.

Transparency: ETFs disclose their holdings daily, allowing investors to track the performance of their investments and make informed decisions.

Diversification:  ETFs offer a convenient way to invest in a diversified portfolio of assets such as stocks, bonds, commodities and currency and help investors to reduce risk and optimize returns

Tax Efficiency: ETFs can be more tax-efficient than other investment vehicles due to their structure and the way they are managed. Equity ETF tax on short term gains for less than 12 months is applicable as per the income tax slab rate. However, long term capital gains over a year are taxable at 10 per cent with an exemption limit on gains up to Rs 1 lakh.

Accessibility: ETFs are readily available to a wide range of investors, including individual investors, institutions, and financial advisors.

Also read: Layoffs in 2023: How to manage your finances amid job cuts 

Disadvantages of Exchange Traded Funds or ETFs

According to experts, following are the disadvantages of ETFs 

Market Risk: ETFs are subject to market risk, just like any other investment. The value of an ETF can fluctuate with changes in the underlying assets. 

Tracking Error: ETFs may not always track their underlying index perfectly, which can result in a "tracking error" where the ETF's performance deviates from the index.

Trading Costs: While ETFs typically have lower expense ratios than actively managed mutual funds, they can still incur trading costs, such as brokerage fees, transaction costs and taxes which can impact returns.

Reduced Flexibility: Unlike individual stocks or mutual funds, ETFs cannot be customized to meet specific investment goals or strategies. This can limit an investor's ability to tailor their portfolio to their individual needs.

Liquidity: Although ETFs are generally liquid, the liquidity of specific ETFs can vary depending on the size and trading volume of the fund.

Regulatory risk: Changes in laws and regulations can negatively impact ETFs, such as restrictions on investments in certain countries or industries.

Should one invest in ETFs?

According to Ranu, brokers and investors who want to invest passively can choose the ETF option as the return would be commensurate with the benchmark return minus the expense ratio. 

Pritam suggests doing thorough research before making an investment in exchange-traded funds (ETFs). 

Nidhi said that investors looking for low cost and tax efficient investments which will give them market linked returns can consider investing in Exchange Traded Funds. She added that ETFs are suitable for investors with moderate to high-risk appetite and before investing investors should consider their financial goals and investment horizons.

Also read: Layoffs in 2023: How to manage your finances amid job cuts