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Understanding ETFs: A Comprehensive Guide to Exchange-Traded Funds

Sebencapital

Published
08/08/24
Understanding ETFs: A Comprehensive Guide to Exchange-Traded Funds


Introduction to ETF

ETF (Exchange-Traded Funds) were first launched in the USA in 1993. Since then, they have gained popularity not just in America but also worldwide. In India, the first such fund, Nifty Bees, was launched in 2002 and has since delivered an impressive 1914.15% growth (absolute returns). Despite the growing popularity, many investors remain more familiar with stocks and mutual funds, with less awareness of this investment vehicle.

This article provides a beginner’s guide to understanding these funds.

What is an Exchange-Traded Fund (ETF)?

An Exchange-Traded Fund is similar to a mutual fund but with some unique features. Like mutual funds, these funds collect money from investors, are managed by a fund manager, and have a Net Asset Value (NAV). However, there are two main differences:

  1. Tradability: Unlike regular mutual funds, these funds are traded on stock exchanges.
  2. Passive Management: These funds are typically passive, often tracking benchmark indices like Nifty or Sensex. Fund managers purchase the stocks in these indices to ensure the fund’s returns closely mirror those of the index.

Just like stocks, they are listed on stock exchanges, allowing investors to trade them through their brokers.


Categories of Exchange-Traded Funds(ETF)

These funds can be divided into four main categories:

  1. Equity Funds: These track the performance of stock indexes or a group of stocks from a specific industry or sector.
  2. Gold Funds: They invest in gold bullion, allowing investors to include gold in their portfolio without holding physical gold.
  3. International Funds: These mimic the returns of foreign stock indexes, offering access to foreign markets and economies.
  4. Debt Funds: These funds purchase fixed-income assets and are actively traded on the NSE, often at a lower cost than debt mutual funds.

Advantages of ETF

Investing in these funds offers several benefits:

  • Diversification: They provide exposure to a broad selection of assets, which helps diversify and strengthen your portfolio.
  • Liquidity: Like shares, these funds can be easily traded on stock exchanges throughout the day.
  • Market Pricing: Units are exchanged at market values, offering potential benefits if market perceptions favor the sector or market they track.
  • Lower Expense Ratio: The cost of managing these funds is generally lower compared to traditional mutual funds.

How to Select an ETF

When choosing a fund, consider the following aspects:

  • Category: Decide on the category—equity, gold, international, or debt—based on your investment goals.
  • Trading Volume: Choose a fund with good liquidity to avoid issues with buying or selling.
  • Expense Ratio: Opt for a fund with a lower expense ratio to maximize your returns.
  • Tracking Error: Select a fund with minimal discrepancy between the index and the fund's returns.

Comparing ETFs, Stocks, and Mutual Funds

ParticularsExchange-Traded FundsStocksMutual Funds
What is it?A basket of securitiesSingle securityInvestment pooling in assets
RisksDiversified, market-relatedHigher, based on companyDiversified, market-related
TradingThroughout the dayThroughout the dayOnce a day after market closes
ControlLess than stocks, more than mutual fundsMost controlLeast control

Key Takeaways

  • Unlike regular mutual funds, these funds can be traded on stock exchanges.
  • They are passively managed, which generally results in a lower expense ratio.
  • They typically track a benchmark index or a specific sector.

Conclusion

Exchange-Traded Funds (ETFs) offer a versatile investment option for both novice and experienced investors. They combine the best features of stocks and mutual funds, providing the diversification of a mutual fund with the flexibility of stock trading. With lower expense ratios and the ability to be traded throughout the day, ETFs are cost-effective and accessible. Their passive management style, often linked to benchmark indices, makes them a straightforward choice for those looking to invest in broader market segments or specific sectors. However, it’s essential to consider factors like liquidity, expense ratios, and tracking errors when selecting an ETF. As awareness grows, these funds are becoming an increasingly popular tool for portfolio diversification, offering a balanced approach to achieving long-term financial goals. Overall, ETFs are a valuable addition to an investor's toolkit, providing an efficient way to gain exposure to a wide range of assets.


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Written by devesh gupta

I am Devesh Gupta, a Junior Analyst at Seben Capital, where I specialize in finance with a focus on market research and data analysis. I support investment decisions by translating complex financial data into actionable insights. My role at Seben Capital allows me to contribute significantly to our investment strategies, leveraging my analytical skills to drive success.

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